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they are legally set up as corporations or not) are commonly referred to as private companies
if they are owned by a few individuals and other people are not generally presented with
the opportunity to buy into the company’s ownership.
In such cases calculating a dividend yield requires an educated guess of the stock’s fair
market value.Example 6.1.6 Dave believes that each share of stock in the dry cleaning business is
worth $8,000. Based on this estimate, what is the dividend yield?$350 per quarter annualizes to $1,400 per year. So the dividend yield is $1,400/$8,000
17.5%.The dividend yield calculated in this example is only as good as the estimate of the busi-
ness’s value. If Jason thinks the business has a higher value than Dave does, and believes
each share is worth $14,000, he would calculate the yield to be just 10%. Even though a
17.5% seems completely different from a 10% rate, they are both based on the same $350
quarterly payout.Capital Gains and Total Return
Dividends are one way that an investor hopes to profit from a stock investment, but they
are not the only one, or even necessarily the main one. Often an investor buys shares in
a business in the hopes that the business itself will grow and become more valuable, and
that down the road she can sell her shares for more than she paid for them. Profits due to
the increase in value of an investment are called capital gains. Historically, publicly traded
stock prices have tended to rise on average—though the performance of individual stocks
varies wildly—and a large percentage of the profits from stock market investments have
come from capital gains. Similarly, the owner of a private company normally would expect
(or at least hope) that over time the value of the business will increase, so that, if and when
he decides to sell, it will command a higher price.
While both are a way of profiting from an investment, there are significant differences
between capital gains and dividends. If you own shares in Zarofire Systems, for example,
you receive any dividends the company declares while you own the stock. You get the
dividends in cash and can do with them as you please. If you bought your shares for $25 a
share, and the price of the stock rises to $100 a share, on paper you have a profit of $75 per
share. But you don’t actually have this as money you can spend unless you sell your stock.
If the market price of the stock declines, your “profit” can disappear.
There are some advantages to capital gains over dividends, though. When dividends
are paid, they are income to you, and so they are subject to income tax. Capital gains
are not considered income until you make them income by selling, and so you do not
pay income taxes on those gains until you sell the stock. It is also the case that capital
gains may be taxed at a different (usually lower) rate than dividends. Some companies
and investors prefer that a stock not pay large dividends and invest almost all its profits
in growing the business, the idea being that this will provide the opportunity for greater
capital gains.
Calculating a rate of return from capital gains requires a bit of algebra. The compounded
rate of growth can be approximated by the Rule of 72, but to get a more exact measurement
we can manipulate the compound interest formula:FV PV(1 i)nDividing both sides by PV, we get:(^) PVFV (1 i)n
The next step requires a bit of more advanced algebra. (Readers not familiar with the rules
of exponents will have to take this next step on faith... .)
(^) FVPV (^)
1⁄n
1 i
6.1 Stocks 255