When it comes to stocks there are two ways to make a profit, which are very different, but correlate very strong and in different directions. The first way to earn money from holding a share is through dividends, which is basically the portion of the companys earnings that is paid to stockholders. The dividend yield is calculated by dividing the dividend per share by the current market price of the share.
Example: if a company pays 10 cents as annual dividend per share and the current market price of the share is 1 dollar, the dividend yield equals 0,1/1 = 10%.
The second way to profit from owning a share is called capital gains and it basically consists in buying a share at one price and selling it later at a higher price, after different types of events have caused the companys value to rise.
Example: if we buy a share today, which costs $1 and we sell it in 1 month following an increase in the companys value for $1.10, we will have a capital gain of ($1.10-$1)/$1= 10%.
Dividend Yield
Most companies pay dividends for their common and preferred stocks on a quarterly or annual basis. Stocks, which pay out a fairly good dividend are referred to as income stocks. The amount of dividends, distributed among the stockholders is completely up to the board of directors. They can raise, reduce or completely eliminate the dividend payments and there is no law that can predetermine or reverse their decisions. Companies however tend to follow their dividend payment trends, because a sudden complete stop or a drastic drop of dividend payout may indicate to the market that a company has severe financial problems.
Even if that is not the particular case, a negative reading by the market players might mean an instant stock devaluation and sellout. On the other side, when a company manages to raise its net earnings, it tends to increase the dividend payout with a slower pace, so that more money can be channeled back in, which will lead to further growth in the next period. Both of the cases depend completely on the companies practices and stockholder profile and can vary. For example, some corporations stockholders, who are risk averse and generally at an older age, prefer a higher dividend yield. Such stocks are basically used as a regular income source and the companies behind them usually have reasonably stable income flows so that they can assure regular dividend payments.
Other shareholders are risk prone and prefer that the company reinvests all of its net earnings so that it can achieve a lot bigger growth in the future, which will increase its value and lead to higher capital gains. There are also many individual cases of strategic moves, which aim at reaching above the ordinary goals. For example, companies have paid a lot higher than the average dividend in a time when share prices have dropped, so that the company boosts its stockholders declining confidence, ensuring them in its prospects of future recovery and growth.
Often stocks are also preferred as a way of earning money through your savings, when the expected receipt of dividend is higher than the interest rate on saving accounts. Some people do hold shares for their dividend yield, depending on the amount of risk they want to be exposed to, but most investors are attracted mainly by the opportunity of high capital gains.
Capital Gains
Generally, when purchasing shares, an investor expects that the companys value will grow over time, which would make his shares more expensive, thus earning him money, if he sells them later at a higher price. Some market players, called speculators, buy stocks with the intention to sell them over a short-time span and earn through the price difference. Companies, which are expected to grow over time are called growth stocks. Many of these companies pay very little dividend or none at all so that they reinvest most of their earnings in order to expand and improve, which will lead to further growth in the next year.
There are of course such companies, which pay very little or no dividends and in the same time have almost zero growth, which leads to no profit for the stockholders at all. Such companies are called “dogs” and generally must be avoided, unless there is some fundamental factor that is about to take place, which could spark up growth and thus profits in the future through capital gains or even dividends, when the financial state improves. Either way, especially for a newcomer to the world of investing, it is important to avoid such stocks or at least to do a lot of research into it and the market the company is operating in, if you have decided to risk and invest there.
What is also very important when investing in stocks, apart from avoiding the bad performing ones, is being able to identify which ones are income and which growth stocks. There are of course shares, which have mixed properties. They provide a bit of both types of income. There are shares, which start as growth stocks, but then switch to income ones. Or it could be the other way around. A company could experience a lack of money to expand, which would make the board of directors decide not to pay out any dividend and reinvest all earnings. Some investors make a portfolio, consisting of all three different types of stocks by yield – income stocks, growth stocks and such with mixed properties.
This strategy aims at diversification and balance between the dividend yield, which makes you wealthier at the current moment through the regular payouts, and the long-term capital gain earnings in lets say 3-5 years and more. Every investor forms his own strategy, which suits his needs. Some rely on the regular payments to support their standard of living, but are also paying dividend taxes regularly. Others, who lets say currently have an excess of money, prefer to invest in the long term, cash in higher earnings after some years and pay only once the so-called capital gains tax. In any case scenario, identifying the types of shares according to their yield type is crucial for building a portfolio, which suits properly your risk profile and your needs. The best way to do that is by conducting a research into the companys history of net earnings, dividend payments, fluctuations of share prices, innovations and reinvestment, market share and growth. Every bit of information can lead to a better decision.
Most successful investors suggest that aiming at stocks with high dividend yield is alone not enough and could be a big mistake. According to Dale Gillham from Wealth Within, a high dividend yield can mean three things:
– A high dividend yield can be a sign of a falling share price and/or an unprofitable company, which is more common.
– A high dividend yield can mean the company is very profitable as it has spare cash to give investors.
– Often a high dividend yield is unsustainable because of point one above.
Just the % dividend yield as a number means very little and can mislead you. A 10% dividend yield from a $1 share is one thing, 10% from a $0,5 share is two times lower. Also, it wouldnt be a good investment if you buy stocks with high dividend payments for $10 per stock and in 2 years the company loses a lot of its value and its shares drop to $5. Professionals suggest that a good investment must have both capital gain and dividend yield as that is a sign of a healthy company. A healthy company has stable income flows and a capacity to increase them in the future, which is the foundation for both dividend payments and capital gains – hardly a company, which earns less than it spends will increase its market capitalization.
A growing and successful company, which has solid earnings that will increase in the future will regularly pay out and most likely will increase its dividend payments in the following periods, thus making it more attractive. Investors meanwhile will start buying out its shares, thus driving prices up, which will result in capital gains for the older stockholders. Thats why the most important thing when investing is to select companies, which are likely to make profit and increase it in the future.