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If you are thinking of investing by buying one, your question would be—how does it earn? In this post, I’m going to discuss the two ways a stock can earn an income for an investor like you.
In What is a stock, I talked about the two types of a stock: common and preferred. In both types, they earn you returns through:
- capital gain
A dividend is a part of the profit of the company that it decides to give back to investors. It can be redeemed by stockholders either through cash or by buying more stocks.
A person who owns preferred stock gets regular, periodic pay-out of dividends. On the other hand, those with common stocks are usually informed that dividend payments are not guaranteed.
Capital gains mean that the price of the stock has increased.
But why do stock prices increase? And why do they decrease? The price of stock is dictated by two forces: fundamental value and its market value.
Its fundamental value is the worth of the business. Many different experts have many different interpretations of what constitutes fundamental value.
The simplest explanation is that it is the entire sum of the business if it is going to be sold. It is computed by getting the worth of every asset it owns minus all debts with the result divided by all stocks.
However, the actual stock price may differ from its fundamental value. This is because stocks of any company are limited and the market—buyers and sellers—creates a supply and demand of this limited resource.
When this happens, the price of the stock is whatever buyers are willing to pay and whatever sellers are willing to let go.
At times, the price can be higher. And you gain by buying when it was low and selling when it is high.
The increase in stock price can be due to an increase in desirability of the company, as a response to a really good business performance or the generally good economic conditions driving an increase in the demand for stocks.
However, the price can be lower. And you lose by buying when it was high and selling when it is low.
Remember that the capital gain or loss is only realized when you decide to sell it to another buyer or give it back to the company who then buys it back from you. Until then, whatever gain the stock has is declared on paper. That is the reason why it is called a paper asset.
Bringing it all together
Let us say that you purchased a stock worth P10.00 for a company ABC123. For a year, you received quarterly dividend of P1.00, for a total of P4.00 for one whole year.
After the first year, you decide to sell the stock and someone is willing to pay you P15.00. If we do not consider the cost of buying and selling your stock, then the total returns for investing is P4.00 (dividends) + P5.00 (capital gains) which is P9.00.
The above assumes that you buy direct shares. That is, you participate in owning stocks from companies that are listed in the Philippine Stocks Exchange.
However, most of us will be buying a managed fund as it does not require the same amount of work and skills as buying direct shares. The managed fund, like an investment-linked policy, reflect all returns in the net asset value per units (NAVPU).
The price of each unit reflect all the returns from all of the invested assets. So instead of receiving either a dividend or capital gain from each of the direct shares, what you get is the increase of the price of the unit.