Investing Basics – What is A Stock and What Happens to Profits?

My last post talked about deciding upon a 100% stock allocation as I was starting out on our investment journey. I failed to mention that before making this bold decision, I spent an enormous amount of time reading about stocks, profits and their valuation principles.

It seems a bit daunting to try and learn investment concepts when you are starting from square one. I decided it was probably best to learn it in a similar fashion to medicine, which meant starting with the core building blocks. I find when you understand the base principles of a topic it creates a more fundamental belief system around your knowledge base.

My reading began with what a stock truly was. The hardest part of understanding a new concept is all the jargon and finance is no different.  Unfortunately this post is quite didactic in nature but I felt it was needed to make sure other concepts are understood as I progress deeper into investing ideas. I decided to split it into 2 posts so that it would be easier to digest.  As you learn more about stocks, I believe you can grasp why they have a tendency to outperform other asset classes in the long run. This will strengthen your resolve during tumultuous market conditions.

Basic Definition

A stock (also called an equity) simply represents a fractional ownership of a real business and entitles the owner to an equivalent fractional ownership of the company’s profits.

The primary purpose of any business it to create a product that is in demand which will achieve profits for its owners.  These profits exist only after business expenses and loan obligations are paid as part of general business operations.

If an individual has 1/1000th proportional share of a company, they have a theoretical right to 1/1000th of the company’s profits. In practice, most investors hold a miniscule fraction of the proportional shares of a company.

The various options of what can be done with business profit is called capital allocation.

Capital Allocation Of Profits

  1. Capital Return

Unfortunately, a shareholder can’t demand their cash any time they feel like it. The company CEO and Executive have the right to determine the best use of its profits. I will create an imaginary company to show some of the options a CEO may have.

Imagine a company that trades on the market at $10/ share and has annual profits of $1/share after all expenses. The total amount of shares outstanding for the whole company is 100 million shares (also known as the share count).

The total value of the company also known as Market Cap is 100 million shares outstanding x $10/share = $1 billion total market valuation

It has $1/ share of profit or $100 million annual profit based on the share count.

Sometimes the company may decide to share some of its profits with the shareholders via a form of capital return. The 2 main forms of capital return are: dividends and share buybacks.

A. Paying out Dividends

This is often a quarterly amount that is given for each share of the company owned. This typically happens when a company has a history of consistent profits in a stable industry. Imagine the company has had consistent $100 million annual profits for many years and has always felt comfortable sharing $20 million of those profits annually via a regular dividend policy with its shareholders.

$20 million would be $.20/share. Remember this will be split over 4 different regular payments throughout the year which is $.05/share quarterly.

The dividend yield is the annual dividend/ total cost per share paid.

$0.20 dividend / $10 cost =2% dividend yield.

The dividend payout ratio is the percentage of total profits that is being directed to pay the dividend.

$20 million dividend/ $100 million total profit = 20% payout ratio.

The average company with a dividend policy currently pays out around 30% of its profits currently. A company that is reaching a payout ratio of 80-90% may have trouble continuing to pay a dividend. This may happen if its profitability has dropped off temporarily. It is important to remember that a dividend is a choice for a company and not a requirement. Many companies choose to never pay a regular dividend and others may choose to end a dividend payment if profits aren’t sufficient to allow it.

A company can also choose to randomly give out a special dividend if a sudden dramatic level of profits falls to the company (think of an asset sale or an extremely profitable year)

Dividends are often sought by investors looking for a predictable cash flow such as in retirement. This allows retirees to retain the ability to achieve stock/equity like returns which they would not get from bonds. These investors have to remember that the dividend may be cut if company profits are dropping.  A dividend cut often leads to a drop in the stock price as dividend investors sell to find a different stock that still pays a dividend. The cash flow from dividends would generally be riskier than that from bonds.

Other investors that don’t need the cash flow may choose to enroll in a dividend reinvestment plan (DRIP) which can automatically purchase additional shares of the company without the extra trading commission cost. This would be ideal if the cash isn’t needed currently and the investor is in the wealth accumulation stage.

2) Buying back shares

This will reduce the overall number of shares outstanding for a company, which means future profits will be split amongst less shareholders. This reduced count increases the proportional profit/share in the future.

In our example, imagine that the company takes $20 million of its profits and buys shares in the open market at an average price of $10/ share = 2 million shares purchased. They cancel these shares and now there is only 98 million shares moving forward.

The next year its $100 million profit is divided by only 98 million shares = $1.02/share. This seems like a much smaller capital return than the $0.20 received in dividends when dividends were chosen as the type of capital return. The difference is that increases in long term per share earnings often will lead to increased valuation of a company.

Often share buybacks make the most sense when a company believes their stock price is trading below what their estimate of what its true value is. This leads down a complicated valuation discussion which we will avoid for purposes of this post.

The other main benefit of share buybacks is that they are a form of capital return to investors without triggering a taxable event like when dividends or interest are received. Since the buyback leads to increased profit/share in the future, this can correlate with an increased share price and the investor will only trigger a taxable event when they decide to sell the stock. Hence, this form of capital return creates a tax deferral as long as the investor holds the stock.

2. Retained Earnings For Growth

 

A company may feel that it has better use for capital than giving it back to shareholders via a capital return. Competition from other similar companies within an industry is a constant threat to future profitability. Often growing the companies size to gain a larger share of the overall market demand is seen as a way to stay competitive in an industry. This can be done by using profits to in two main ways:

Organic growth

This type of growth is by re-investing profits into the core business to increase future profits. This could be by buying better or more equipment, higher more employees, or investing in more research and development to gain more advantages in the future.

An excellent example of organic growth would be Amazon. Jeff Bezos has taken company profits and constantly re-invested in further expenditures that allow Amazon to have incredible logistics and reduced consumer pricing. Amazon has gained significant market share from traditional retailers via this strategy and can now compete in many different consumer spending areas given their advanced logistics and distribution network.

Inorganic growth

This is acquiring growth from the purchase of other related businesses to quickly access the market share of the acquired company. There may be cost saving synergies to the core business that can also improve long term profitability. This type of growth is regulated by the government to ensure no company is buying its way into a monopoly/oligopoly environment to reduce competition.

Continuing with the Amazon example, its recent purchase of Whole Foods was an example of inorganic growth. It gave Amazon quick access to retail infrastructure and knowledge of handling grocery distribution to start competing against low cost grocers like Costco etc.

Shareholder Rights

A final option for company profits is to pay out bonuses to employees or the executive. These are called Incentive Packages and are meant to attract and keep talented employees. It can be done via cash bonuses or by issuing stock options. The incentive packages are determined by the company Board of Directors.

The only input a minority shareholder has into business decisions is the legal right to vote their proportional amount of shares to select the Board of Directors that they feel best represents their interest in how a company should be run. They have the right to attend the annual shareholder meeting  to voice any concerns on the business. Since most shareholders hold a fraction of 1% of the total shares, the term outside, passive minority shareholder (OPMI) refers to the little influence they over the direction of the company.

This is in contrast to a majority shareholder who holds over 50% of a public company can always influence decisions since they can vote their majority portion of shares to remove board members if the company direction is not going the way they like. Some large institutional investors (think pension funds or large hedge funds) may hold enough stock to request a board seat and influence change at the BoD level. An activist investor is one that buys up a significant portion of a company with plans to come in and create a plan to influence the direction of a company.

The final legal right a shareholder has it to sell its fractional stock ownership to another buyer on a public stock exchange at whatever the current quoted value of the business is. It is important to remember that every buy and sell transaction occurs between 2 individual entities. This happens on the stock exchange where each buy/sell entity has a stock brokerage ( think RBC, Questrade etc) who processes the transaction on behalf of the entity for a fee. Most amateur investors choose to purchase groups of stocks through mutual funds, index funds or ETF’s instead of selecting individual stocks. Which type makes the most sense is essentially the whole active investing (trying to beat the average market return) vs passive investing (trying to mimic the markets return with low fees) debate which I will discuss shortly in the Financial Independence series.

Stayed Tuned for Part 2!

 

 

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2 comments On Investing Basics – What is A Stock and What Happens to Profits?

  • I just discovered your blog today! Great material and nice to come across another Canadian physician finance blogger. I particularly like your mental strategy of thinking of your portfolio value with a bear market discount factor.

    • Hi Loonie Doctor

      Thanks for the kind words and the link on your blogroll page! I just learned about you and Dr Networth as other Canadian Physician finance blogs as well.

      Both of you are creating some great content and looks like we all have the same objective to improve financial literacy amongst Canadian physicians.

      Keep up the prodigious writing – my newborn has slowed me down considerably!

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