Stocks in summary:
- By buying shares of stock in a company you become a part-owner in that firm. You participate in the continued success of the company through gains in the price of your shares of ownership, and in most cases suffer a loss of all of your investment in the case of company bankruptcy. Stocks represent equity ownership in the firm (thus stocks are also referred to as “equities”) and are thus the riskiest type of company investment due to their lowest seniority level in company bankruptcy hearings
- Stock investors are rewarded for taking this risk primarily through increases in share prices (capital gains) and also through periodic cash dividend payments from firms who choose to pay a dividend
- Both of these types of return receive a relative tax advantage – they are generally taxed at a flat rate of 15 percent instead of at your marginal income tax rate seen in previous investment types
- Though prices are more volatile, stock investors are rewarded for taking on the highest risk in company investment through higher returns compared to fixed income investments
- It is critical that young professional investors use stock investments as their primary long-term investment of choice in order to provide for the highest return potential over our long-term investment horizons
Companies may choose to issue shares of stock to the public in order to raise money to fund additional projects or as a way for a privately owned company’s owners to “cash-out” and receive cash in exchange for some of their ownership in the company. Each share of stock effectively represents a partial claim on the earnings or net income of the company (how much money the company is making after all expenses and interest payments to bondholders), and each share is given voting rights in helping to determine how the company directs their business. Shareholders elect a Board of Directors who represent them and influence the company’s management to make decisions in the best interest of shareholders. This is important since if poor decisions are made by management and the company enters bankruptcy then stock shareholders are behind bank lenders and bond investors in their claim on the firm’s possessions. In almost all bankruptcy cases there is little to no money left after selling off the company’s assets to return invested money to shareholders.
Once a company issues shares to the public their shares continue to trade on a daily basis through a stock exchange. Major U.S. stock exchanges include the New York Stock Exchange (NYSE), and the National Association of Securities Dealers Automatic Quotations (NASDAQ) while smaller exchanges also exist. In the U.S. there are roughly 4,000 companies that have issued ownership shares to the public and trade on these exchanges.
The main determinant of the value of your share of stock in the company is based on how much money the company is earning, and what are their prospects for growing that amount of money they make in the future. A critical measure of a share’s worth is the company’s “earnings per share” – or how much money are they making divided by how many shares of stock in the company exist. For example, if a company earns $1,000,000 in a year and has 1,000,000 shares of stock held by investors, then the company has earned $1/share. If the same company only had 100,000 shares of stock issued to investors then the firm has earned $10/share. All else equal, the higher the amount of earnings or net income created per share of stock, and the ability of a company to grow that value over time, leads to a higher value placed on each share of stock.
A company can decide to either take the money it earns and reinvest it in new projects to further increase net income, or they can decide to pass a portion of this money to shareholders in the form of a dividend. Dividends are declared on a per share basis (for example $0.50 paid per share) and are normally paid to investors on a quarterly basis. Not all companies pay a dividend since they may see a better use of their money by reinvesting this cash into their business (normally seen in smaller/newer companies and technology firms), thus hopefully providing for a gain in earnings per share down the road.
When a company increases their earnings per share or increases their prospects for growth, the value of each share will likely increase. This gain in share price is known as a capital gain and is a primary source of return for stock investors when they sell shares in the future for more then what they purchased them for. This type of gain receives a tax advantage when investors hold their shares for longer than one year (providing for “long-term capital gains”) and the gain is generally taxed only at 15 percent by the federal government (higher tax rates can apply if your annual income is above $200,000). Gains in share price received in a stock holding that was held for less than one year long (“short-term capital gains”) do not receive this advantage and the gain is instead taxed at your marginal tax bracket. Dividend income is also generally taxed at the lower fixed rate of 15 percent. Both sources of return in stock investing are generally taxed at a lower rate compared to all the other investment choices we have reviewed thus far (thus leaving you with more money!).
Let’s go through an example to show a key difference between stock and fixed-income investing based on “Company X”:
- Current credit rating by Standard & Poors = A
- Current earnings per share = $1.00
- Current price of a $1,000 bond maturing in 10 years = $1,000 providing a coupon yield of 5 percent
- Current stock price = $10
Compare an investor who bought a bond for $1,000 and an investor who bought 100 shares of stock at $10 each for $1,000.
Now say Company X just created an excellent new product which will provide for a steady stream of new sales for many years into the future. This will likely affect both their credit rating and their earnings per share. Once their credit rating was increased to “AA” then the required interest rate for investors in the bond could lower to 4 percent, resulting in a gain in the price of the bond. If earnings per share increased to $1.50 due to the new product then the stock price would also likely rise. Both investors saw a gain on their investment (with the stock price likely rising much more than the bond price), but only the equity holder will participate in the continued growth of the company. If both investors continue to hold their investments then the bondholder will never realize this gain. In 10 years they will get their initial investment of $1,000 back, but stockholders will have still have their shares which are now more valuable. The bond investor did see a temporary gain in the price of their bond, but if they keep the bond until the loan is returned (maturity) then they never realize a gain due to the success of the company – they just get their money back along with a 5 percent yield each year along the way. The stockholder receives the benefits from the company’s success and continues to do so as earnings per share increase.
When you buy shares of stock in a company you are making a long-term bet on the continued success and growth of the firm – their ability to reach new customers across the globe, their use of new technology to improve the efficiency of their operations or to develop new innovative products, the continued growth of the global economy, and the success of globalization and capitalism – all very powerful forces! When you invest in a bond for the long-term, you get a fixed return and your initial investment back at the end. And your returns from interest payments are taxed higher than your dividends and capital gains!
In the following pages on equity investing we will provide much more detail on stock characteristics and show you the dramatic differences in long-term investment gain potential by making the long-term bets we just mentioned compared to investing in a bond. But the main takeaway right now is that though it is the riskiest type of company investment, it is the type of investment that you must focus on to give you the best long-term return potential.