101-05 Investing in the Stock Market

Investing in the Stock Market

There are various strategies that can be used to make money in the stock markets.  These include investing for dividends, investing in penny stocks, blue chips, small-capitalization stocks “small caps”, exchange-traded funds (ETF’s), mutual funds, hedge funds, and real estate investment trusts (REITS).

In this section, we take an overview of the terminology and the vehicles available to invest in.

Buying Stocks for Growth

Most people associate the stock market with the rise and fall of stock prices. And that is certainly a major aspect. The appreciation of a stock’s price is the most common form of profiting from the stock market.

You purchase a stock at $10 and sell it for $12 this equates to a 20% profit excluding transaction costs and taxes on the gains.

Relying on the profit source to be the stock price means you would inevitably want to invest in growth stocks, i.e. stocks experiencing a price appreciation at or better than the market average.

Growth stocks may typically be companies that are relatively new to the market and have carved out a profitable niche that is growing at a rapid pace.  The factors to consider in growth stocks are:

  • How long will the growth last?
  • Can the company turn fast growth into profits?
  • Can the company dominate the market in its niche?
  • How experienced are the management team?

In addition to looking at price growth, one should consider any dividends a company may be paying.

Buying Value Stocks

Value investing is both a philosophy and a strategy of investment. The philosophy is that an asset’s value is its most important characteristic. The strategy is that the market cannot properly value stocks, but well-informed investors can.

Value gurus like Warren Buffett believe most stocks are either overvalued or undervalued.

Buying Stocks for Dividends

Of the 5800+ stocks currently available to purchase on the major U.S. indices circa 2800 companies currently offer a dividend payout.

A dividend is an offer from the company to pay out a portion of its income (after-tax profits) to its shareholders.

These companies tend to be well established with a stable income stream enabling them to offer a constant dividend.  The dividend is essentially a reward to the shareholder for holding the stock.

Types of Dividend

  • Regular Cash dividend, the most common type of dividend payment, usually released quarterly.
  • Extra dividend is a special dividend usually a large one-off payment to shareholders
  • Liquidating dividends usually paid if there are any left-over or allocated funds during the company’s liquidation.

Dividend Payment

The dividend payment is usually expressed in dollars per share.  This means if you own 100 shares of a company whose stock price is $200, if the company pays out $5 per share then I will receive 100 X $5 = a $500 payment.  Usually, this is distributed on a quarterly basis, meaning I will receive $125 per quarter.

Dividend Payment = Number of Shares X Payment per Share

Dividend Yield

Here is an example of the dividend yield.  Joe owns 1000 shares of ABC Company at a cost of $10 per share.  ABC pays out a regular dividend of $0.50 per share.  As a single share of the company is worth $10, $0.50 equates to a dividend yield of 5%.

Dividend Yield = Annual Dividend Paid / Stock Price

This 5% is essentially what you earn on your money regardless of stock price growth.  Of course, if the stock price deteriorates during the period in which you hold the stock this may mean your net profit reduces.  For example, you make a 5% profit in terms of dividend yield, yet the stock price has depreciated 5%.  This means your net profit if you were to sell would be zero.

How to Calculate Stock Dividend Yield With Easy Examples

 

Dividend Payout Ratio

This is the proportion of the Earnings per share that is paid out in dividends.  For example, if a company earns $2.50 in earnings for every outstanding share and it pays out $0.50 per share in dividends, then the dividend payout ratio is 20%.

Dividend Payout Ratio = Dividends per Share / Earnings per Share

Ex-Dividend Date

This is the date two business days prior to when the dividend payment is scheduled.

For example, if you purchase a stock on April 24th and the company announces the dividend payment date is April 30th, then you will be entitled to the dividend.  However, if you purchased the stock on the 29th of April, then the previous owner of the stock will receive the dividend.

What kind of dividend payouts can you expect?

Of the 5000+ stocks currently on the major U.S. Indices, approximately 50% of the companies pay out a dividend.  Here are some interesting facts.

  • There are 2800 companies paying a dividend
  • Less than 0.5% pay-out a dividend of more than 10%
  • 25% of the companies pay out a dividend yield of between 5% and 10%
  • Less than 1% of companies pay a dividend of less than 1%
  • This means approximately 74% of the companies pay between 1% and 5%

A reasonable expectation is that you should receive a dividend of around 5%.

Dividends can be a great way to generate a steady income from stocks, but beware if a stock price is rapidly falling and the company is in trouble your net profit may not be as high as you expect.

6 Steps to Build Your Dividend Stock Screener & Strategy

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