A stock is simply a small piece of a company. A “public” company is one that has issued shares by selling them to the general public. Once those shares have been sold, investors can trade the stock among themselves on a market like the New York Stock Exchange or the Nasdaq.
When you buy shares of a company, you become a co-owner. As an owner, you have, in theory, a right to piece of the profits the company generates. But the ways those profits end up in investors’ pockets (if at all) will vary from stock to stock.
“There are three sources of return from equities,” says Pat Dorsey, chief investment strategist at Florida money management firm Sanibel Captiva Investment Management. “First is the dividends you get, second is growth in earnings and third is change in valuation.”
A company can pay out part of profits in the form of regular dividend checks, which may be paid quarterly or in the form of “one-off” special dividends. (Another way a company can give profits back to shareholders is by buying back some stock.)
But many very profitable companies don’t pay dividends at all. Instead, they reinvest profits back into the business in hopes of increasing earnings even more. Shareholders who think that a company has strong growth potential may be happy to forgo a dividend today as long as they think the new investments will increase the future earnings of the business. The more profitable a company is, the more other investors ought to be willing to pay for it. That’s because even if the company isn’t paying dividends now, higher profits mean its theoretical future dividends will be that much fatter.
The third factor, valuation, is a matter of perception. Sometimes investors might be optimistic and willing to pay, say, twenty times a company’s per share earnings for a stock. Other times the market will go bearish, and other investors will only be willing to pay ten times. All these factors together are what make stock investing so uncertain. You not only have to make a prediction about how a company’s earnings will grow, but guess about how others in the market will value those earnings. It is possible to lose money on a stock with high dividends and growing earnings. Likewise, some stocks can rise in value for some time without turning a profit.
Since 1928, stocks as a group have earned about 10% per year, vs. 5% to 6% for bonds. These high average returns mask, however, some years of sharp losses and long stretches of low returns. Equities returned less than 1% annualized from 2000 through 2010, as bonds earned 6%. You can’t get higher returns without taking real risks.