To the dismay of income investors, Warren Buffett's Berkshire Hathaway (NYSE: BRK-A ) (NYSE: BRK-B ) doesn't pay a dividend, and likely will not in 2014, but there is one sure way you can make money from the company run by one of the greatest investors of all time.
A hypothetical scenario
In his most recent annual report, Buffett proposed a hypothetical scenario of someone who owns half of a $2 million business that will grow its value by 12% per year, and can be sold for 1.25 times its on-paper value to an outside investor at any time.
He then details a scenario where one third of the income (that 12% growth) is paid out in dividends each year, and then the rest is reinvested in the company. After the first year, the company would've made $240,000, and the individual would have received $40,000 in dividends. At the end of 10 years, the $1 million investment would've resulted in $660,000 in dividends being paid out, and the value of the 50% stake would have turned into $2.7 million. Certainly something we could all hope for!
However Buffet then outlines a different scenario, where everything is the same, except the company doesn't pay out any dividends and instead reinvests all of the money it earns back into the firm. The owner then takes it on themselves to sell 3.2% of their stake in the company each year. So at the end of the first year, they would receive $40,000 (yes, the same amount) for selling 3.2% of their 50% stake at 1.25 times what it is worth on paper.
At the end of 10 years in the second scenario, despite having a 14% lower stake in the company, the market value of the ownership would be greater (at $2.8 million) and the individual would have received more proceeds from the share sales, at $680,000.
At the end of year 10, the value of each scenario is available as follows:
A real-life example
Considering almost all of Buffett's wealth is in the stock of Berkshire Hathaway, you can see why he's chosen to follow the reinvestment route versus the dividend one.
Buffett understands the reality that almost all investors have different goals through different plans, and have differing needs for cash. Someone in their 20s will likely have a much longer time horizon to consider before they ever need the tangible proceeds from an investment when compared to someone in their 60s. By not paying dividends, Buffett empowers the shareholders of Berkshire Hathaway to sell the stock when they need to based on their own situations.
Consider that Buffett -- through Berkshire Hathaway -- has resoundingly beaten the market over the past 20 years, even after you consider dividends paid out to investors:
As you can see, since 1993 -- which have been some of the more difficult in the history of Berkshire Hathaway -- its stock has returned an average of 12.5% annually, versus the S&P 500 returning 9% including dividends.
In a hypothetical scenario where both of those hold true over the next 20 years (of course, knowing past performance doesn't always guarantee future results), if you invested $100,000 in Berkshire Hathaway today and sold 5% of your shares each year, at those growth rates, at the end of 20 years, you would have collected $230,000 through the proceeds of share sales, and your investment would still be worth almost $400,000, for a total of $630,000.
Using the same scenario with the assumption of the last 20 years of data, an investment in the S&P 500 of the same $100,000 would have a total value of $560,000, a difference of $70,000, or nearly 70% on the initial investment.
While Buffett may not send you cash directly through Berkshire Hathaway, his resoundingly strong returns each year can let you squeeze cash out of his great company and create your own dividend plan.
Wisdom from Warren
There is good reason why Warren Buffett has made billions through his investing, and the understanding of dividends is just one example. The good news is he's been happy to share that knowledge continually and he wants you to be able to invest like him. Through the years, Buffett has offered up investing tips to shareholders of Berkshire Hathaway. Now you can tap into the best of Warren Buffett's wisdom in a new special report from The Motley Fool. Click here now for a free copy of this invaluable report.