Share ownership, particularly in publicly traded corporations, serves as a cornerstone of personal finance and wealth-building strategies. Often, the motivation behind such investments can be summarized in a simple phrase: to make money! But how exactly does owning shares generate wealth, and why should investors be keen on incorporating these assets into their portfolios? This article delves into the nuanced reasons behind owning shares of a publicly traded corporation.
Capital Appreciation: The Foundation of Profitable Investments
When investors purchase shares, they are essentially taking a long position. This means they anticipate that the company will either boost its earnings and profit margins or maintain its current robust performance. The primary way investors can earn through stocks is capital appreciation.
Capital appreciation refers to the increase in the market price of a company’s shares over time. This rise in value is influenced by factors such as the company's performance and the overall investor sentiment. A favorable shift in either can lead to share price escalation. Investors who sell their shares at a higher price than their purchase point follow the principle of 'Buy low, sell high', thus realizing a gain.
Take, for example, an investment of 100 shares in Corporation ABC at $10 per share. If these shares appreciate to $11 each, selling them would generate a profit of $1 per share, equivalent to $100. This is the realized gain on capital appreciation. The potential for capital appreciation underscores the allure of owning shares in a publicly traded corporation.
Dividends: A Tangible Share of Company Profits
The second income stream that appeals to investors is dividends. Companies that find themselves with surplus cash, instead of reinvesting it all back into the company, might opt to distribute dividends to their shareholders.
Assuming you own 100 shares in Corporation ABC, and the company declares a dividend of $1 per share, you are entitled to a $100 dividend payment. The power of dividends lies in their flexibility; they can be received as income or reinvested to leverage the compounding effect of appreciation over time.
Historically, market performance reflected in the S&P 500 shows that return rates are markedly higher when dividends are reinvested instead of taken as income. This strategy, over two or three decades, can drastically improve the final value of an investment portfolio, greatly influencing an investor's quality of life post-retirement.
Mergers and Acquisitions (M&A): A Window for Potential Windfall
The final lucrative opportunity that shares in publicly traded corporations can offer comes in the form of mergers and acquisitions (M&A). In an M&A scenario, shareholders can realize significant capital appreciation.
Let's illustrate this with an example. If Corporation ABC, priced at $10 per share, is acquired by a larger competitor, DEF, at a rate of $20 per share, shareholders witness an instant capital appreciation of $10 per share, or 100%. In such scenarios, shareholders may receive the value of their shares either in cash or in the form of a stock swap with the acquiring company.
Investing in the shares of publicly traded corporations opens doors to various forms of wealth accumulation, be it capital appreciation, dividends, or the benefits from mergers and acquisitions. It's an opportunity to be part of a corporation's growth story while diversifying one's investment portfolio and enhancing potential returns. Therefore, the question isn't why you'd want to own shares in a publicly traded corporation, but rather why wouldn't you?
Summary:
There are three ways to make money on stocks:
The market price for a share of a company’s stock can go up or down according to the company’s performance and market sentiment surrounding the company. When the price of the shares you own increases, your holdings have experienced capital appreciation.
If you sell them at that point, you would have followed the old adage “Buy low, sell high.”
For example, if you bought 100 shares of corporation ABC at $10/share, and the next day/month/year, the shares were valued at $11/share, selling the shares would generate a profit of $1/share times the number of shares you own, or $100. The $100 is called your Realized Gain on Capital Appreciation of the stock.
If you had kept the stock, the $100 would be referred to as your Unrealized Gain on Capital Appreciation of the stock. Conversely, if the stock were valued at $9/share instead of $11, $100 would be your Unrealized Loss, and if you sold the stock at $9/share, you would have $100 of Realized Capital Loss.
2) Dividends:
If a corporation decides they have extra cash they may not want to reinvest into the company, the corporation can decide to pay out “dividends" to its shareholders.
For example, if you own 100 shares of ABC, and ABC decides to pay out $1 per share to its shareholders, you would receive $100 in dividends. Dividends can be taken as income or reinvested.
When reinvested, they add to the compounding effects of appreciation over time. When looking at the historical performance of the market using the S&P 500, the average rate of return is significantly higher when historical dividends are reinvested instead of just taken as income.
Just a few percentage points over a 20-30 year timespan can make a monumental difference in the ending value of a portfolio and the quality of the investor’s lifestyle in retirement.
Suppose company ABC is trading at $10/share, and its competitor, the larger company DEF, purchases ABC and buys the stock for $20/share. Then, the shareholders would enjoy a Capital Appreciation of $10, or 100%.
The shareholder could either receive cash or shares of the bigger company equal to the amount of the appreciation, which is called a stock swap.
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