Stocks

When people buy stock in a company, they commonly say they are buying "shares."  This is an apt term because they are literally becoming a part-owner of the business with the right to share in its earnings and net worth.  Shares of common stock of a company come into existence when the company sells those shares to investors in exchange for cash.  That is how companies raise capital to build factories, develop products and finance their business.  After that initial transaction, the shares can be bought and sold by other investors at whatever price they agree on in what is referred to as the "secondary market" (the "primary market" being the initial transaction that enabled the company to raise capital).  The company receives no direct benefit from any transactions in the secondary market--the proceeds of a transaction go to the selling investor.  But a company is keenly interested in the stock price because typically the managers own a fair chunk of it.  In addition, if a company needs to issue more shares to raise additional capital, the price of the stock in the secondary market will pretty much determine the price of the newly issued stock.  When a company issues new stock it dilutes the percentage of ownership of existing stockholders, so it wants to issue as few shares of new stock as it can--and the higher price the fewer shares it has to issue to raise a given amount of money.  And if a company pays a dividend to stockholders, the fewer shares outstanding the less cash it has to payout in dividends.

Many factors influence the price of a stock.  In theory, you can calculate the value of shares to the penny.  If you own 1% of the shares of a company, you own 1% of its net worth--a figure the company's accountants determine every quarter and is equal to the excess of a company's assets over its liabilities.  Theoretically a company could sell all those assets at the value on its books, pay off its debts, and distribute that net worth to its shareholders.  In reality of course companies are not about to liquidate themselves and if they did, they might realize a lot more (or a lot less) than the amounts on their books.  On the other hand, investment analysts certainly look at the net worth, or "book value", of a company because it is one way of evaluating the value of a company.

Earnings--a company's net income after taxes--are the primary determinant of a company's stock price, especially the prospect of growth in those earnings.  Dividends, the only way a company has of directly rewarding its stockholders since it does not control the stock price, are paid out of earnings so as earnings grow investors can anticipate growth in dividends.  This is why earnings per share (EPS) is such an important, eagerly anticipated number every quarter on Wall Street.  Dividends per share is also important, but remember some companies have plenty of earnings but pay no dividends.  In stead of paying out their earnings in the form of a dividend, they reinvest that money in new products, new markets and even new businesses--arguing that they have better opportunities than their shareholders have if they were to take dividends and reinvest them.

The last step in the stock pricing puzzle is evaluating the worth of those earnings.  Earnings, and the dividends sometimes paid out, represent a recurring stream of income generated on an ongoing basis, year after year.  Without getting too deep into financial theory, streams of future cash payments can be translated into a single number reflecting a lump sum an investor would pay to receive those future payments.  In the case of shares of stock, that number is the price of the stock.  A lot of variables effect that calculation: anticipated inflation rates, current short-term and long-term interest rates, the certainty of those future earnings and their growth rate. 

What's important is that over the years, earnings have grown and stock prices have grown. Historically held over the long term have performed significantly better than savings accounts or bonds.  According to one study, for every fifteen-year holding period between 1930 and 1976 the New York Stock Exchange listings as a group provided an annual return (assuming dividends were reinvested) of between 8 and 22 percent., with the majority of these periods in the 11 to 16 per cent range.  There was only one fifteen-year period out of thirty that did not reach 8 percent.  In the same study ten-year holding periods were found to be somewhat more erratic but only two periods out of thirty-five registered lower than 8 percent average annual growth.

As a result, financial pros tend to agree that investing in stocks with a strong record of dividend growth may be the best strategy for retirement income.