Welcome back to Personal Finance for Professionals Part II, our multi-lesson series teaching you everything you ever wanted to know about investing in stocks and bonds. In Lesson Two, we learned all the reasons companies sell stocks, and in this short Lesson Three, we’ll discover why investors buy them.
Understanding Stocks
Investing in Stocks
How Does an Investor Make Money from a Stock?
Now that we know why a company would sell stock, why would anyone buy it? The short answer is that it allows the owner of the stock to participate in the company’s future. A stockholder is betting that the company will be profitable and/or will become more valuable over time. There are two ways an investor can make money from stock: by receiving dividends and through capital appreciation.
Dividends
When a company is profitable, it may distribute some or all of its profits to shareholders through a direct payment, or dividend. However, a company has no obligation to pay dividends.
Let’s say that Company A earns $1,000,000 in profits this year and pays out $500,000 in dividends to shareholders, leaving $500,000 in retained earnings, which is used to improve or grow the business.
Dividends are expressed on a per-share basis, allowing each owner to benefit in proportion to their ownership. Since Company A has 5,000,000 shares outstanding, each share entitles the owner to $0.10 per share per year.
$500,000 dividends / 5,000,000 shares outstanding = $0.10 per share
For public companies, this is expressed as a dividend yield, which is the percentage of the stock’s share price paid out each year. However, in practice, dividends are typically paid quarterly, or four times per year.
The share price of a company is determined by how much people are willing to pay for a share of the business on the open market. We will discuss this in detail later.
Company A stock price = $4.00 per share
Dividend payout $0.10 per share
Yield = $0.10/$4.00 = 0.025 (2.5%)
A stockholder who bought 1,000 shares of Company A at $4 per share paid $4,000 total and will receive $100 in yearly dividends paid out at $25 per quarter. 2.5% of $4,000 is $100.
Dividends provide a regular income stream, allowing you to receive a return on your investment without selling your shares. However, dividends are not guaranteed. A company can start, stop, increase, or decrease them at management’s discretion. There are other drawbacks as well. First, dividends received by shareholders are taxed as ordinary income. Next, companies that pay dividends are often perceived as mature businesses without much room for growth. If management had a better use for the money, such as expansion or new business lines, they would retain the profits to fund them internally.
Capital Appreciation
The second way an investor can make money from a stock is through capital appreciation, which is an increase in the value of the company. If a business becomes larger and more profitable over time, its stock price can rise, making each share more valuable.
Company A (CPYA) kept $500,000 in profits as retained earnings, which it used to make and sell more products, thereby increasing its profits the following year. The stock price went up from $4 per share to $7 per share, making 1,000 shares worth $7,000.
An investor who purchased 1000 shares for $4,000 could now sell them for $7,000. We say that the investor has an unrealized capital gain of $3,000. Once they sell, they will realize capital gains and pay taxes on them. If an investor has held the shares for at least 1 year, the gains are treated as long-term capital gains and taxed at a special (lower) rate. If the shares were held for less than 1 year, any gains are treated as short-term capital gains and taxed as ordinary income.
The benefits of capital appreciation for the investor are that it is not taxed until realized and that the tax rate is lower for long-term gains. The downside is that a stock’s price doesn’t always go up. Management may retain earnings to grow the business, only to fail. If an investor sells a stock for less than they paid for it, it is called a capital loss.
Putting it Together
A stock investor is essentially paying to ride the coattails of a business. When the business makes money, the investor may receive some of the profits as dividends. If the business grows and/or becomes more profitable, the company’s valuation may increase, leading to a higher stock price and thus capital appreciation for the investor.
If Ruth purchased 1,000 shares of Slater Industries at the IPO price of $20 per share, she invested $20,000. When the stock price rose to $30, Ruth now has an investment worth $30,000, for an unrealized capital gain of $10,000. If she sells all her shares, she will recognize a realized capital gain of $10,000 and will have to pay taxes on that amount only.
A Word of Caution – The Hubris of Doctors
Before we begin our discussion of how to invest in stocks, I want to give healthcare professionals, especially medical doctors, a word of caution. Excelling at one thing (becoming a physician) does not automatically make you good at anything else. Doctors are notoriously bad investors and pilots (look up twin-engine doctor-killers).
You will hear your colleagues talk in the office, OR, or doctor’s lounge, about how they made a killing on this stock or that investment. Take this with a grain of salt. People tend to brag about their successes without mentioning their failures.
You have spent an inordinate amount of time studying physiology, taking standardized tests, and practicing to become a physician. You have most likely not been studying finance, advanced mathematics, or computer modeling, let alone a public company’s 10Ks, 10Qs, and proxy statements. Wall Street has a small army of graduates from prestigious universities working 80-hour weeks trying to beat the market. Do you really think you are smarter or can work harder at investing than they do? And let me give you a little preview . . . most of the time, even professional investors don’t beat the market.
This doesn’t mean that doctors shouldn’t invest in stocks. Quite the contrary, I believe that every medical professional should not only buy stocks, but that it should be the cornerstone of their investment portfolio. Just be humble. You’re not the next Warren Buffett or Peter Lynch. You’re not even the next Michael Burry or William Bernstein (famous investors and doctors).
Thanks for reading. Leave any comments and questions below. And, if you are enjoying this series, please subscribe to the blog so you won’t miss Lesson Four, where you will learn different ways to invest in stocks. It will be a riveting installment.