Stocks
Investing in shares is very popular. Public stock companies are listed at an exchange, such as the New York Stock Exchange or the London Stock Exchange, but it is also possible to buy shares in non-public stock companies. In the olden days, a share purchase would involve the physical delivery of a share certificate to the buyer. Today, shares are normally recorded digitally instead, e.g. in the UK-based Certificateless Registry for Electronic Share Transfer (CREST).
The capital stock of a corporation constitutes the equity stake of the corporation’s owners. The stock of the corporation is partitioned into shares. When you own at least one share in a company, you are a shareholder which means that you are one of the owners of that company. In everyday language, the terms stock and share is often used interchangeably.
Investing in stocks might feel like a modern pursuit, but stock companies were around as early as the Roman Republic. There were even two different types of shares available for sale in the republic: partes and particulae. Partes were issued only by large cooperatives, so investing in them was probably a bit similar to investing in a Dow 30 corporation today.
Different types of shares
Shares of common stock
Shares of common stock is the “standard” type of shares, and many companies only have common stock. In most jurisdictions, shares of common stock always come with voting rights.
Shares of preferred stock
Shares of preferred stock will typically come with no voting rights. So, why would anyone want to invest in a company without begin allowed to vote? The short answer is that the owner of preferred shares (also known as preference shares) has the right to receive dividend payments before any dividends are paid out to the owners of common stock shares. Preferred shares will also be given preferential treatment if the corporation goes into liquidation, which means that the chances (however small) of getting something of value out of the liquidation process is higher for the owner of a preferred share compared to the owner of a common share.
Convertible shares of preferred stock
The owner of this type of share has the right to convert the convertible preferred share into a fixed number of common shares. When convertible shares of preferred stock are issued by a company, it will usually involve setting a specific date before which no conversion can take place.
Investing in stocks
Even though it is definitely possible to make your stock investment strategy considerably more complicated if you want to, the two basic ways for making money on stocks are these:
- Buy a share, and then sell it for more than you paid for it.
- Buy a share, and hold on to it while receiving dividend payments.
Stock dividends
Stock dividends are paid by a corporation to its shareholders. Dividends can be paid out in the form of cash or in the form of something else, e.g. shares or valuable items.
Example of a dividend payment: Company EEE is paying dividends on common shares. Each share gets $5. This means that Sarah, who owns 200 common shares in Company EEE, will get 200 x $5 = $1,000 in dividend payments. Erica, who owns 750 common shares in Company EEE, will get 750 x $5 = $$3,750 in dividend payments.
It is usually rather mature companies that pay dividends. A new company is much more likely to either have no profit to pay out, or prefer to keep the profit and use the money to expand and develop the company. Before any dividends are paid, the paying of dividends must be approved by the shareholders.
Examples of sectors that traditionally have included plenty of high-dividend companies are basic materials, oil & gas, real estate, utilities, bank & financial, and health care & pharmaceuticals.
Preferred shares enjoy preferential treatment when it comes to dividend payments (see above), since they are paid first. In most jurisdictions, it is legal for a corporation to pay out dividends to the preference shares only, without making any payment of dividends to shares of common stock.
Fixed scheduled dividends
Public companies that pay out dividends will usually have a fixed schedule for dividend payments. One payment per quarter is a popular choice.
How much to pay out can be determined in several different ways. Some companies does for instance adhere to a stable dividend policy, where the company aims to make a steady payout of similarly sized dividends even if the exact company profit varies from one quarter to the other, and also from year to year.
Example: Each quarter, Company X pays $2 per share in dividends.
Another option is to simply decide on a specific percentage and then pay out that percentage of the profit each time. The amount paid out on each share will then vary from one payment event to another, if the profitability of the company varies.
Example: Each year, Company X pays out 30% of their profits from the year before. For the year 2016, the profits were $100 million, so $30 million were paid out the following year, $7.5 million per quarter. For the year 2017, the profits were $150 million, so $45 million were paid out the following year, $11.25 million per quarter.
A third method is to employ a residual dividend policy. The firm will retain a part of the profits to finance the equity portion of its capital budget, while the rest of the profits are payed out to the shareholders.
Special dividends
A special dividend payment takes place outside the standard schedule for dividend payments.
- A corporation can for instance decide to sell off a major asset and distribute the proceeds to the shareholders instead of retaining the money.
- If a company has achieved unusually strong earnings, but isn’t expected to be able to sustain this increase in profit, it can be a good idea to distribute the “strange” extra profit to the shareholders in the form of a special dividend payment.
- A third example of a situation where a special dividend payment can be a good idea is when the company has made a significant change to its financial structure, e.g. changed it debt ratio.
Preferential tax treatment
In many jurisdictions, dividend payments are favorable treated by the tax system. It may for instance not count as income from capital at all, or only partly count.
Example:
- You sell 10 shares in Company EEE for $40 per share. You purchased them for $25 per share. The difference is $150. In your jurisdiction, this profit is taxed as income from capital and you pay 30% tax on it. $150 x 30% = $45. You get to keep $105.
- You own 10 shares in Company EEE. You get a $15 dividend payment per share, a total of $150. In your jurisdiction, dividend payments are exempt and do not count as taxable income. You get to keep $150.
As you can see, the difference between getting money from a stock sale and getting money from dividends can be large when tax is taken into account. The overall difference for someones economy can be even more significant if that person is in a high marginal tax bracket and $150 from a profitable share sale would push the person into a new tax bracket, while a dividend payment would not push them anywhere.
What’s a DRIP?
In finance, the acronym DRIP stands for Dividend Re-Investment Program. By signing up with a DRIP, dividend money paid out to you on your shares will never reach you. Instead, the money will be automatically utilized to reinvest in the underlying stock (i.e. purchase shares) for you.
Example: You have 100 common stock shares in Company EEE. You receive a $1 dividend payment per share. You are signed up with a DRIP, so your $100 is automatically used to purchase more shares in Company EEE. The share price at the time of purchase is $5 so you get 20 shares. You now have 120 common stock shares in Company EEE. The next time there is a $1 dividend payment per share, you will get $120. If you are still signed up with the DRIP, the $120 will be used to buy more shares in Company EEE.