Back to basics: What are equities?
When an investor buys a share (also know as ‘equity’), they become a part owner of that company. This entitles them to a share of any profits (via dividends) and to participate in the company’s growth. However, this also works the other way – if a company does badly, investors will see their investment depreciate.
Let’s look at the income side of things first. Companies will often pay out part of their profits in the form of a dividend. This is not guaranteed: The directors of a company choose how much to pay out in any one year and they are not obliged to make a payout at all. The only exception to this are preference shares or preferred stock, which do usually carry a fixed rate of dividend, but in practice most investors treat these in much the same way as they do bonds. In practice, many companies have a long-running commitment to pay a dividend to shareholders. Cutting the dividend can be a key indicator of problems within the business and will frequently also cause a drop in the share price, thus both making the company more vulnerable to a take-over and leading to general shareholder dissatisfaction.
If you want to track the dividend policy of a company, you can do it by using the dividend payout ratio. This operates in two ways, one at the level of one individual share, and the other at the level of the company as a whole (though both should give the same result!).The inverse of the dividend payout ratio is called the retention ratio. Whichever one of these you choose to use, they are valuable analysis tools.
Is a company maintaining the dividend yield, but only at the expense of paying out more and more of the company’s profits? If so, how will it fund any necessary capital expenditure in coming years, and what areas might it be starving of cash – new product development, perhaps?
On the other hand, if a business has a large cash pile but is distributing a relatively small amount of earnings every year, then might it not do better to increase the dividend yield, or even to offer to buy back some of its shares from the shareholders?
The capital growth (or loss) an investor receives from investing in shares is the difference between the price at which they buy and the price at which they sell. There is considerable debate about what makes a share price rise, though a company’s profitability, its balance sheet strength and its revenue growth are all likely to contribute to a higher share price in the long-term. Buying at a relatively low price can also help the capital growth of your shares. This is not easy to do, but watching the movement of share prices, and how they respond to company announcements can help you build a picture of a company’s relative strength.