The primary benefits of common stock come down to two basics: capital appreciation and income.
Capital appreciation, also called growth or a capital gain, happens when an investment’s value rises above its original purchase price. For example, if you buy a stock at $50 and sell it at $75, you have a $25 capital gain. Because there’s no set limit on how high a stock price can rise, common stock has unlimited gain potential. As the market climbs, the investor’s potential gain increases. This is the most common form of return from a common stock investment.
Gains are unrealized until you sell the investment. Stock prices can fluctuate significantly. For example, during the early stages of COVID-19 in the United States, the S&P 500 fell 12.5% in March 2020, then rebounded and rose 12.6% in April 2020. For context, the S&P averages around a 10% return annually. In other words, the market moved about as much as it often does in a year - but in a single month. The key point is that you must sell a security to “lock in” a capital gain. Once you sell, the gain becomes a realized gain. Until then, the value can rise or fall.
Growth stocks are the most likely to provide capital appreciation. These are stocks of companies expected to grow business revenue in the future, often at a faster rate than the overall economy. Many newer businesses fit this description because they’re trying to expand operations and increase revenue. While not necessarily considered growth companies today, companies like McDonald’s, Walmart, and Home Depot were growth companies in their early stages. Today, they’re large companies that are most likely beyond their rapid-growth phase.
Some large, well-established companies are still considered growth companies. For example, while Amazon is large and well-established, it continues expanding its business operations and attempting ventures in new industries. Amazon uses business profits to expand through mass hiring of new employees, buying out other companies, and continually improving its current operations.
Amazon has never paid a cash dividend, which is common for growth companies. Cash dividends are corporate earnings shared with investors. Growth companies generally don’t pay dividends because they prefer to reinvest profits into expansion. If a company believes it can create more value for investors by reinvesting earnings back into the business, it may choose not to pay a dividend.
Income from cash dividends is the other way investors can make money on common stock. While growth companies rarely pay dividends, larger, well-established companies that are beyond their rapid-growth phase often do. McDonald’s, Walmart, and Home Depot all pay quarterly cash dividends to their investors.
Many large dividend-paying companies focus on maintaining or slowly increasing market share, rather than pursuing major expansions. Consider Walmart: it already has a global presence and generates around $500 billion annually in revenue, which makes it a blue chip company.
Because Walmart isn’t spending as much of its revenue on major expansion, it can pay a larger portion of earnings to shareholders. In fact, its dividend payout ratio is usually around 40% annually. This ratio compares the company’s annual earnings to how much it pays out to investors as dividends. Here’s the dividend payout ratio formula:
Continuing with Walmart, let’s use its 2019 (fiscal year) financials to calculate its dividend payout ratio:
What is Walmart’s dividend payout ratio?
Answer: 40.6%
Value companies are also known for paying cash dividends to shareholders. If a stock is trading at a “bargain,” it’s considered a value stock. This is most likely to occur with larger, well-established companies. If a company doesn’t have a successful business model or generate meaningful revenue, it’s harder to argue that its stock is a “good deal.” Value companies often pay dividends that are large relative to their stock price.
As discussed in the cash dividends section, some investors build large dividend-paying stock positions and live off the income. This can be especially useful for retired investors who want dividend payments to replace employment income.
Dividends are not guaranteed, which affects both risk and return. Companies can reduce or completely eliminate cash dividend payments at any time. This often happens during economic downturns. Many companies reduced or ended dividend payments in the Great Recession of 2008 and throughout the COVID-19 crisis.
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