The primary benefits of common stock can be boiled down to two basics: capital appreciation and income.
Capital appreciation, also known as growth or a capital gain, occurs when an investment’s value rises above its original purchase price. For example, a stock purchased at $50 and sold at $75 results in a $25 capital gain. With no ceiling to how high the stock market can climb, common stock has unlimited gain potential. The further the market climbs, the more the investor gains. This is the most common form of return from a common stock investment.
Gains are unrealized until an investment is sold. The stock market can fluctuate considerably; for example, the stock market performance in the early stages of COVID-19 in the United States. The S&P 500 was down 12.5% in March 2020, while it rebounded and increased by 12.6% in April 2020. For context, the S&P averages around a 10% return annually. The stock market was moving as much as it does in a year but in the span of a month. Bottom line - investors must sell a security to “lock in” capital gains, which is known as a realized gain. Until that occurs, the investor could be in for a wild ride.
Growth stocks are most likely to provide capital appreciation. These are stocks of companies poised to see growth in their business revenue in the future and typically grow at a faster rate than the economy. Every new business is a growth company attempting to expand its business operations and revenue. While not necessarily considered growth companies today, companies like McDonald’s, Walmart, and Home Depot were growth companies in their early stages. Today, these are large companies that are most likely beyond their growth phase.
Some large and well-established companies are still considered growth companies. While Amazon is large and well-established, the company is still expanding its business operations and attempting ventures in new industries. Amazon uses its business profits to expand its business through mass hiring of new employees, buying out other companies, and continually improving their current operations.
Amazon has never paid a cash dividend, which is a staple of growth companies. Cash dividends represent corporate earnings shared with investors. Growth companies generally don’t pay dividends so they can spend their profits on business expansion. If the company believes it can make more money for its investors by reinvesting earnings back into the business, why would it pay a dividend?
Income from cash dividends is the other way to make money on common stock. While growth companies rarely pay dividends, larger, well-established companies beyond their growth phase usually do. McDonald’s, Walmart, and Home Depot all pay quarterly cash dividends to their investors.
Many large dividend-paying companies attempt to retain or slowly build their market share, but significant business expansions are typically not in their plans. Think about it - how much do you expect Walmart’s business to grow? They already have a global presence and make around $500 billion annually in revenue, making them a blue chip company.
Because Walmart isn’t spending significant amounts of its revenue on business expansion, it pays a large chunk of its earnings to shareholders. In fact, its dividend payout ratio is usually around 40% annually. This ratio measures the annual earnings of the company versus how much is paid out to investors. Here’s the dividend payout ratio formula:
Continuing with Walmart, let’s look at its 2019 (fiscal year) financials and calculate its dividend payout ratio:
What is Walmart’s dividend payout ratio?
Value companies are also known for paying cash dividends to shareholders. If a stock is trading at a “bargain,” it’s 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 make a fair amount of revenue, it’s more difficult to consider its stock a “good deal.” Value companies often pay dividends that are large in comparison to their stock price.
As we discussed in the cash dividends section, investors can build large dividend-paying stock positions and live off the income. This is a great benefit for retired investors, who can replace their employment checks with dividend payments.
Dividends are not guaranteed, which has consequences for risk and return. Companies can reduce or completely cut cash dividend payments at any time. This typically happens in 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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