The share price is the primary focus when making an investment in a stock. But there are other ways that the company can use to provide a return to the shareholders, their owners.
When a business earns profits, some of those profits are re-invested into the business. This may be for research and development, which can be a significant investment for a pharmaceutical company, for example, or they may invest their profits in additional store locations or by expanding into new markets, for example entering foreign markets. They may choose to acquire a smaller competitor as a way to grow. In many cases they can make these investments and still have money left over. The management may then decide to return some of these profits to the owners.
The most common way to do this is to pay a dividend. The company will decide how much of their profits they want to pay out in dividends. They must be sure they have enough left in the business for investments they will need to make especially since once they start paying the dividend, investors will assume that they will continue to do so and ideally increase the payout over time. Once they decide the amount that can be distributed, this will be expressed as a per share amount. Let’s assume that the company has decided to pay a dividend of $1.00 per share. Generally, the dividend will be paid quarterly, so the quarterly dividend will be $0.25 per share. We can now determine the dividend yield for the stock. Think of the dividend yield like an interest rate. If we have a savings account that pays 5%, then we refer to that as its yield. For a stock we can calculate the dividend yield by expressing the dividend payment as a percent of the stock price. So, if I pay $20.00 per share for the stock and receive a $1.00 annual dividend, then the dividend yield is 5% ($1.00 / $20.00 = .05 or 5%). At the time I purchase the stock, I am “locking in” this yield. A new purchaser may pay more or less for the stock in which case he will have a different yield. Not all companies pay a dividend. Young, fast growing companies want to retain all of their earnings to reinvest in their growth. So, generally, more mature, stable companies are able to pay a dividend. Once they start they want to be able to continue to pay the dividend year after year because to cut or eliminate the dividend as taken as a very negative sign on the company’s future prospects. This can provide a very valuable aspect to stock investing. Knowing that you can expect to receive the dividend payment each year and have the potential for the stock price to increase over time provides a double opportunity for profit from your investment. There are many studies which show that over time dividend paying stocks outperform non-dividend payers.
Another way that a business can choose to invest their profits is with a stock buy back. The company can designate a certain amount of money that will be used over time to purchase their own stock on the open market. Why would they do this? Presumably, after looking at their available options for re-investing their profits, they have decided that their stock represents a good value. They may consider that the “market” isn’t giving their stock the value it deserves. So, how does this benefit their shareholders? In two ways: to a lesser degree the additional buying may tend to drive the share price up. The primary way this benefits their existing shareholders is that it reduces the number of shares outstanding. As a result each share of stock represents a slightly larger ownership stake. Now when you’re dealing with millions (and sometimes billions) of shares outstanding, this difference may be slight. But some companies will have multi-year programs for buying their stock and over time this can have a measurable effect. Let’s look at a simple example. If a company has one million shares outstanding and earns $1 million dollars per year, then their earnings per share (EPS) is $1.00. If the company buys back 100,000 shares the shares outstanding is reduced to 900,000. Assuming that they still earn $1 million, the EPS is now $1.11. This will tend to drive up the share price since each share now represents a larger share of the earnings. Fascinating.
Stock splits do not alter the value of the business or of the shares, but they do change the per share price. We mentioned earlier that stocks sell for all different prices but most are less than $100 per share. Over time the stock of a growing and successful business will increase in price, at least that’s what we would want to happen. If it gets to be quite high, for example $150.00 per share the company may decide that they would like to make their shares more “accessible” for smaller investors. They can accomplish this through a stock split. With the approval of their board of directors, using my example, they can declare a 3 for 1 stock split. On the date when the split becomes effective, they will have 3 times the number of shares outstanding and the stock price will be adjusted accordingly, in this case to $50 per share. So, if I owned 1 share at $150 before the split, I would own 3 shares at $50 each after the split. Nothing has changed in terms of the total value of my investment.