Last Updated on 17 November, 2020 by Samuelsson
Whether it’s on the TV, in the newspapers, or on the internet, it’s almost impossible to stay a day without seeing someone make a comment about stocks or the stock market. It, therefore, makes perfect sense that you want to know why people buy stocks and what the gain from doing so.
People buy stocks because they are looking to get a return on their investment either in the appreciation of the stock value or in the form of dividends. In some cases, the return on investment can be a combination of both.
There is a lot to know about stocks and how people can make money from stocks. Keep reading to find out more.
What Is a Stock?
A stock is a type of investment that offers you proportionate ownership in the company that issued it. The size of your stake in the company is dependent on the number of shares you own — a share is the basic unit of ownership in a company.
Thus, the stock of a company is the collection of all the shares into which the ownership of the company is divided. When you buy a stock of a company, you own a certain number of shares of that company, which entitles you to a proportion of the company’s profits.
Where Do You Buy Stocks?
Most of the time, you buy stocks from other shareholders in the secondary market, but during public offers, you can buy the shares directly from the company. The stock exchanges make it easier for the public to buy and sell stocks, without dealing with the issuing companies.
Companies issue their stocks to the public to raise funds to finance their various businesses. By sharing the ownership of the company with the interested investors, the issuing company can get the required funds without obligations to pay back, while the investors then become co-owners of the company.
Common Stocks VS Preferred Stocks
Buying stock gives you certain rights in the company that owns the stock. But the kind of right you get depends on the type of stock you buy. Most times, what you get to buy is the common stock, which gives you the right to vote at the shareholders’ meetings and entitles you to the dividends paid on common shares.
However, if you own a preferred stock — which is quite rare — you won’t have the right to vote at the general or special shareholders’ meetings, but you will have a preferential treatment when the company is distributing its earnings. As a preferred shareholder, you will be paid dividends first before the common shareholders are paid. Again, in the event of a liquidation of the company, you are entitled to the proceeds from the company’s assets before the common shareholders.
But, basically, people buy stocks because they want a slice of the profits that a company makes. A company that is consistently making profits may decide to always share the profit among the shareholders — dividends. The company may also retain the profits and use them to grow its business.
As the company grows, its value increases, and if it remains successful over time, its stock will eventually go up in the long run.
Let’s have a look at how people make money from owning stocks!
How People Get Returns on Stocks?
The returns on a stock investment can come in any of these two ways or a combination of them:
- Capital appreciation
For some investors, their main aim of investing in stocks is to have regular income from dividends. A dividend is a reward a company gives to its shareholders for their loyalty to the company. It is the distribution of a portion of the company’s profits to the qualifying stockholders. Most times, a dividend is paid as cash — check or direct deposit in the investors’ bank accounts — but if the company has a share repurchase plan (it is trying to buy back its own shares), the dividend can be paid as shares of the stock.
Dividends are distributed according to the number of outstanding shares in the company, so the amount received by each shareholder is proportionate to the number of shares each person holds in the company. For an investor with a sizeable stake, dividends can be a regular source of income.
How much Do Companies Pay in Dividends?
A company doesn’t pay out all of its earnings to the shareholders; it retains the major portion of the profits (retained earnings) to fund day-to-day operations of the company. It is the duty of the board of directors to decide if dividends will be paid to the shareholders, the percentage of the profits that will be paid out, and when the dividends will be distributed. However, their decisions must be ratified by the shareholders by voting.
When a company is still at the growing stage, the directors may opt to retain all the profits and use them to fund the expansion of the company, instead of paying dividends. The shareholders may allow this if they believe that the expansion will increase the company’s profitability and the potential to pay bigger dividends in the future. A perfect example of this is Starbucks, which reinvested its earnings to build more coffee shops and later started paying dividends.
An investor whose primary aim is to get regular income from dividends will have to focus on companies that are well-established and making predictable profits. Examples of companies that regularly pay dividends include Coca Cola, Colgate, and Procter and Gamble. In addition, real estate investment trusts (REIT) and master limited partnerships (MLP) companies are designed to regularly pay a certain percentage of their profits to the shareholders.
Dividend Yield VS Dividend Payout
To know a company that offers the best dividend returns, an investor will need to compare their dividend yields — not just the dividend payout. The dividend yield is a ratio of a company’s annual dividend to its current share price, expressed as a percentage.
For example, say company A is trading at $10 per share and pays $1 annual dividend, company B is trading at $20 and pays $1.5, and company C is trading at $30 and pays $2, their dividends yield will be given as follows:
A’s Yield = 100 x 1/10 = 10%
B’s Yield = 100 x 1.5/20 = 7.5%
C’s Yield = 100 x 2/30 = 6.7%
So, A offers the best dividend returns, even though it pays the least amount. Other things being equal, for an investor who is solely interested in dividend income, A will be the best company to invest in.
Most investors buy stocks because the market price of stocks can appreciate with time. Capital appreciation, also known as capital gain, is the increase in the market value of a stock. It is the difference between the amount an investor paid for a stock and the current price of the stock.
For example, if an investor paid $10 per share for a stock and the stock now trades at $15 per share, the capital appreciation is $5 ($15-$10). It can be expressed as a percentage gain, and in this case, it becomes 50%. If the stock price fell from $10 to $7, the capital loss will be $3 or 30%.
It is important to note that capital gain or loss can only be realized when an investor sells his stocks. A combination of the realized capital gain and dividend is known as total return on the investment.
Why Do Stocks appreciate in Value?
Stocks appreciate in value because the market perceives value in the issuing companies. As a company grows in value, it will reflect on its stock, even though it may not be in the short term. A company that retains profit to pursue growth can appreciate in value if investors see that the company’s profitability is increasing as a result of the policy. Berkshire Hathaway, for example, retains its earnings, and its stock has appreciated from $19 to more than $300,000 in the last 50 years.
Stocks of dividend-paying companies tend to appreciate in value if the dividend is regularly increasing. When a dividend-paying company reduces the amount paid, its stock may depreciate. For example, when General Electric reduced their dividend payment by 50% in 2017, its stock fell by more than 7% in the days following the announcement.
People buy stocks because they want to grow their wealth from the returns on their investment. These returns can come from capital appreciation, dividends, or a combination of both.
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