Non-Dividend Paying Stocks and the Negative Value Premium

Abstract

The value premium is the empirical observation that low market/book “value” stocks have higher returns than high market/book “growth” stocks. In this paper, we show that the profitability determined relation between risk and return is distinct for non-dividend paying businesses. High profitability dividend paying stocks have low returns whereas high profitability non-dividend paying stocks have high returns. Since profitability and market values relate positively, dividend paying stocks have a value premium whereas non-dividend paying stocks have a “negative value premium.” We argue that high profitability covers the capital expenditure costs of limited growth prospects for dividend paying firms, which decreases risk and return. Because constraints restrict external financing, firms with less exacting growth limits retain earnings rather than pay dividends to finance business investment. High profitability permits high growth which requires high capital expenditure costs which induces high risk. Consistent with this prediction, we find high returns for high profitability, high market/book, non-dividend paying “growth” stocks, which is a negative value premium.

Keywords: The Value-Premium, Non-Dividend Paying Stocks

JEL Classification: G12, G35