The Equity Advantage: Reinvestment of Earnings

Stocks can increase in value in a way that investments in bonds, real estate, and other asset classes cannot: Companies can distribute between 0% and 100% of their profits to investors as dividends or buybacks of shares, while the remaining 100% at 0. % can be reinvested in the business.

S&P 500 companies tend to retain about half of their earnings and distribute the other half through dividends and buybacks. This earnings reinvestment feature is unique to equity investing.

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By comparison, bondholders receive interest payments, but no portion of those interest payments is automatically reinvested in that same bond or other bonds. Landlords receive rental income, but this income is not automatically reinvested in the property.

Commodities and cryptocurrencies, among other asset classes, do not pay cash flows to their owners because they have no cash flows to begin with. Owners can only redirect their investment into other assets by selling all or part of their stake. Therefore, an “investment” in these asset classes is only a point that prices will rise due to changes in supply and demand.1

Reinvestment of earnings is unique to stocks, but this quality alone is not what attracts investors. Attractiveness is the superior composition that shares have relative to other asset classes.


The average quarterly ROE for US non-financial corporations has averaged 10.7% over 75 years

Chart showing average quarterly ROE for US corporations
Source: St. Louis Fed

US non-financial companies earn a return on equity (ROE) of 11%, according to the St. Fed. Louis. Companies in the S&P 500 earn an average ROE closer to 13%, according to S&P data. (This is no surprise: the more profitable a company is, the more likely it will grow enough to be included in the S&P 500.) This means that if the average company in the S&P 500 reinvests half of its profits at a 13% return, its profits. should grow by 6.5%. The S&P 500’s current dividend plus buyback yield is 3.5%, according to S&P data.

Stock Purchases: Motivations and Consequences Tiles

The combination of earnings growth with the dividend plus buyback yield yields an expected return of 10% on the S&P 500. That’s before taking into account any changes in the index’s earnings multiple or any taxes on dividends or earnings of capital

The result is even better if instead of the entire index, we own several above-average companies that achieve above-average returns on equity. If we can buy them at an attractive yield on the cash profits they generate, and if they can reinvest much of their accumulated earnings at high rates of return over a long period of time, we could very well exceed that 10% before tax, before taxes -multiple compression (or expansion) return figure.

In fact, we prefer our above-average companies not to pay us taxable dividends when they could reinvest that money at high rates of return to drive business growth and create shareholder value.

And let’s not forget, dividends are subject to double taxation (once at the business level and once at the individual level), while retained earnings are only taxed at the business level.

Depending on the index and time frame, long-term US returns have ranged from 7% to 10%. So between reinvesting earnings at 13% or distributing those earnings for shareholders to reinvest in stocks at a rate of return of 7% to 10%, the choice should be obvious. Internal reinvestment is the best bet.

Equity Valuation Tile: Science, Art, or Craft?

Of course, not all companies have such rich prospects for reinvestment. That’s why the choice to retain and reinvest earnings or pay them out to shareholders depends on four factors, in particular:

  1. The price at which the company trades relative to its future cash earnings potential.
  2. The attractive reinvestment opportunities available to the company.
  3. The expected returns on capital you can generate in these reinvestment opportunities.
  4. Current corporate tax rates and tax rates on dividends vs.

If the dynamics between these inputs work well, firms should maximize capital advantage and reinvest their earnings rather than distributing them as dividends or buybacks.

To learn more about the equity advantage and share buybacks in particular, see Motivations and Consequences of Stock Repurchases: A Literature Review by Alvin Chen and Olga A. Obizhaeva of the CFA Institute Research Foundation.

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1. Investors in these asset classes are mere speculators in a Keynesian Beauty Contest. Gold can be made into jewelry and other products and sold. Therefore, gold has value. But cryptocurrencies must be sold at a price higher than what was paid for the investment to be “successful”. Whatever value one investor takes out, another has to pay. Money has changed hands, net of transaction costs, but nothing productive has been delivered.


All posts are the opinion of the author. Therefore, they should not be construed as investment advice, nor do the views expressed necessarily reflect the views of the CFA Institute or the author’s employer.

Image credit: ©Getty Images/Nikada


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Jonathan Cornish, CFA

Jonathan Cornish, CFA, is the founder and portfolio manager of 38x Holdings, a long-biased investment firm based in Miami, Florida. 38x Holdings invests in high quality publicly traded companies with monopoly characteristics. Prior to founding 38x Holdings, Cornish worked for UNC Management Company, a $10 billion endowment fund, in North Carolina. He graduated in 2016 from the McIntire School of Commerce at the University of Virginia, where he played on the men’s tennis team that won three NCAA Team Tennis Championships during his four years. Cornish is from the UK and holds a CFA. He can be contacted at [email protected]

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