Have you ever stopped to think about why a unit of stock is called a share? What exactly are you sharing, and who are you sharing it with?
You may recall that stock represents ownership in a company. As an owner, you are entitled to all the rights and responsibilities of a business owner. In a publicly traded company, your responsibilities are limited to financial commitment to the company; the amount you paid for your shares of stock. Your worst case scenario is that the company becomes insolvent and your stock becomes worthless. Your liability is said to be limited because no one can come after other assets you may have to cover an obligation of the company.
You also enjoy certain rights. The first is the right to vote for the board of directors. The shareholders, as an entirety, elect a board of directors to hire and direct the executive management team. The company’s executives hire and supervise managers who carry out the plans and direction of the executive management team. The managers, in turn, hire the employees who perform the functional tasks of operations.
The second right shared by the stockholders is a right to their proportionate share of profits. As the company makes money, the board of directors has a choice to make. Do they give the stock holders their share of the profits, or do they keep the profits in the business with the intent of growing and expanding the business with the expectation that greater profits can be generated in the future? If profits are kept in the business, the accounts call them retained earnings. Profits distributed to stock holders are called dividends.
Some investors prefer dividends. You have heard the expression “a bird in the hand is worth two in the bush”. Dividends are usually paid in cash and the investor is free to do whatever they wish with their share of the company’s earnings. They can pay their bills, invest in another company, or simply save the cash. Some companies offer investors the opportunity to use their dividends to purchase more shares of stock without having to pay regular trading expenses. These programs are known as DRIPs or Dividend ReInvestment Programs. But regardless of which direction the stock holder takes the tax man commeth. In 2013, the maximum income tax rate on dividends is 20%.
Often it is the tax which motivates investors to shun dividends. Those investors prefer that the company retain its earnings and reinvest in itself. Their hope is that as the company grows in value, so will the price of the stock they own. As the stock value grows, so does the worth of the investor but taxes aren’t an issue until the investor actually sells their stock. If the investor sells the stock for more than they paid for it, the difference is a capital gain. As long as the stock was held for a year or more it is currently taxed at the same rate as dividends. If the stock was held for less than a year, ordinary income tax rates apply.
So the two ways to make money with stocks are Dividends and Capital Gains.
Investors should have a clear understanding of their strategy before purchasing stock so they know the best way to evaluate any potential stock purchase.
Key Terms
- Retained Earnings – profits earned by a company which are kept by the company to fund future growth and development.
- Dividends – stock holders share of the company profits which are distributed in cash.
- DRIP – dividend reinvestment program. A program which allows shareholders to use their dividends to purchase additional shares in the company without paying trading costs.
- Capital Gains – the profit made by selling a stock for more than an investor paid for it.
- Capital Loss – the loss incurred by an investor if they sell their stock for less than they paid for it.
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