How much confidence do you have in your investments? A quick look online will turn up results of get rich quick schemes, people losing serious cash with stocks and general acceptance that the stock market is just another game.
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| Photo by Morgan Housel on Unsplash |
“Kelly Mills initially turned to video games for escape. Then she decided to try her hand at a real world game: the stock market.” - BBC
But the stock market is only a game when people choose to use it as such - because they neglect to leverage the ways the stock market will make you money.
There are three key ways in which a company can provide value to its shareholders - companies are free to perform any of these exclusively or in conjunction as it sees best for that financial year.
1. Reinvestment back into the business
2.
Dividends
3. Stock Buybacks
Reinvestment
Wealth begets wealth, not through magic but by investing. Common methods employed by directors can be increasing the number of outlets, developing a new product or upgrading plant/machinery for improved profits.
The mere news of a potential investment can impact the stock price since a sound investment can secure a long term growth in profit.
Buying other companies
Through mergers and acquisitions a business can gain intellectual property, brands and customers – this sounds promising but done in excess can have a nasty downside.
Companies such as AT&T have purchased a wide range of other businesses and hold and impressive portfolio, however could be easily criticized for over extending themselves and might be better suited to focusing on developing a few products rather than spreading themselves thin with too many products.
Capital expenditures
Capital expenditure (CAPEX) is money a business allocates to purchasing, maintaining and/or improving its fixed assets such as property and equipment. Purchasing a new building or repairing your current one are both viewed as CAPEX.
A pretty boring and expected use of cash, but for most businesses this is the most critical way a business will secure and grow future revenues.
Research and development
Whereas purchasing other business and certain CAPEX
activities might cause a rally in the share price, R&D generally gets a lot
less love when it comes to shareholder sentiment. For this reason many CEOs tend to neglect this area, especially if their executive pay is tied to the stock price.
Research and development is critical for long term prosperity in a company and investors looking to buy and hold stocks for the long term might want to pay attention to a companies R&D pursuits.
Dividends
Dividends are the only ‘direct’ way that a company can
reward its shareholders, they are a share of the after tax profit. Better still, when the dividend is reinvested back into the stock the investor is able to achieve the coveted goal of compounded growth.
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| Photo by Pepi Stojanovski on Unsplash |
No company ever has to offer one, but if one is declared a shareholder is entitled to receive that dividend provided they acquired it prior to the ex-dividend date.
Dividends are commonly associated with older, more established companies and some people even view it as a mark of good financial health that a company can keep paying a dividend or even grow it over time. This can sometimes lead to the unfortunate side
How dividend is calculated
There is an idea that prevails amongst many new investors (and even some more experienced), that a dividend yield is somewhat comparable to an interest rate. That is to say, they will view a stock trading at £10/share with a dividend yield of 2% and use that to calculate the amount they will receive – in this case 20p. The trouble with this line of thinking is that there exists many investors who are after an income, and so take is as a given that the company will adjust the dividends according to the stock price in order to keep the percentage yield the same.
Something to watch out for
Some companies might be better suited to re-investing the cash but would rather produce a dividend, this is so they can be seen as more enticing to dividend investors. In some instance companies may even go into debt just so they can produce a dividend, as Boeing did as the failure of the 737 MAX in 2019.
A company does not need to pay out any dividends and can suspend them, although they will avoid doing this as cutting a dividend looks bad for the firm.
It is important not only to look at the dividend, but also fundamentals of the business including the Earnings per Share (EPS).
Stock Buyback
A stock buyback is somewhat self explanatory – a company buys back its shares from the market in order to drive up the price. Berkshire Hathaway is a company that is well known for delivering returns to its shareholder via a stock buyback rather than a dividend.
One of the advantages for a shareholder is that
value is returned to them in a way without incurring any immediate
taxes such as would be the case for a dividend.There is no need for the shareholder to take any action, they can simply buy, hold and the stock will effectively compound itself.
The way a stock buyback works is a company buys shares so they can take them off the market, reducing the number of outstanding shares.
Supply and demand means that as the number of shares go down, the individual price must go up to achieve the same market capitalization.
Example
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Results before buyback |
Results after £20m buyback |
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Share Price |
£4.00 |
£4.20 |
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EPS |
£0.40 |
£0.42 |
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Shares in issue |
100m |
95m |
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Net Income |
£40m |
£40m |
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Market Capitalisation |
£400m |
£400m |
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This example assumes a consistent P/E ratio and no changes to interest earned on cash or paid in debt – in reality there will be differences. |
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A key metric for companies is the EPS of earning per share
Total Earnings/ total number of shares = EPS
When the denominator goes down, the EPS goes up even though the earnings never changed
This article is not advice and has not been prepared in accordance with legal requirements designed to promote the independence of investment research – no recommendations are given in the buying, selling or holding of any investments. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss.