There was a farmer who has a farm. In this farm there were many chickens. One day, a fox came and ate up all the chickens. The distraught farmer was very unhappy and but came to his senses eventually. He wants to rebuild his farm. So he took his remaining savings of $10 to the neighbouring farm and wish to rebuild his farm. The farmer from the neighbouring farm offered him two choices: (1) He will sell him a chicken at $10 or (2) He will sell him 5 chicks at $10.
The farmer thought to himself: If I buy the chicken, I will be able to get it lay eggs and sell those eggs for cash. I can accumulate the profits I got to rebuild my farm! But another idea struck in his head: If I buy the 5 chicks, I will be able to feed them, nurture them and care for them until they grow into fully grown chickens and sell those chickens at much higher prices than the eggs.
If you are the farmer, what would you do?
Generally to profit from a stock there are two ways, dividends or capital appreciation.
Dividends: The Eggs in the basket
Dividends are paid out by companies to reward their investors for holding their stocks.
Dividends are usually paid out with either cash or in other forms such as extra stocks. Not all companies pay out dividends. Mature companies pay more regular dividends than small cap companies because it is harder for them to reinvest their earnings into projects that are more profitable. Hence, it will be better if they pay out some of their earnings as dividends. On the contrary, smaller companies which are still growing rapidly need to reinvest their earnings into growing their company, thus usually they do not pay dividends.
Cash dividend is a dividend that a company pays out of its earnings, in cold hard cash.
Stock dividend is a dividend that a company pays out using additional stocks to shareholders.
Interim dividend is a dividend that is declared and approved by the board of directors of the company anytime during the year, before the full-year financial results are released.
Final dividend is a dividend that is declared and approved by the board of directors of the company after the full-year financial results is released. It is typically a cash dividend and the amount is higher than the interim dividend. This is because management is unsure of how much cash will be available at the end of the year to be distributed as dividends hence they will be more conservative when distributing interim dividends.
Liquidating dividend is a dividend that is paid not fully out of a company’s retained earnings but rather its current share capital. This is also known as the terminating dividend as the source of the dividends paid is not from the company’s profits. It is a negative sign as the company usually pay out liquidating dividends only when it is winding up.
Lesson: Mature chickens can periodically give you eggs that you can sell to receive income
Capital Appreciation: The Growing chicks
When companies earn profits, they reinvest them into the growth of the company. As the company expands into bigger companies, the value of the company increases. Investors will also be willing to offer higher prices for the higher value of the company, hence stock prices should increase.
If you bought Apple shares at $22 at 1980 when it first IPO-ed, over the years Apple has reinvested its earnings back into its company. Today Apple is worth around $$113.95, a 417% increase from its IPO price!
You buy at $22 and sell at $113.95, you would have realise a capital gain.
Lesson: You grow the “chicks” into chickens and sell them off at a high price.
Choosing the method that suits you the best
Any strategy will encapsulate both aspects; buying dividend stocks will also allow the opportunity for capital gains, buying stocks for capital gain will sometimes reward investors with unexpected dividends.
Dividends provide a steady stream of income annually , while capital gains require time to materialise and grow even though it can potentially beat the returns that you get from dividends in the long run.
How you determine your preferred strategy can also depend on your life stage. If you are a young, driven and energetic adult in your 20s, you can consider putting your money into stocks for capital appreciation as you have a longer investment horizon. This gives more time for your investments to bear fruit. Investing in dividend stocks with a low capital may be discouraging as the amount might be too little for you to feel that your investments are bearing fruit.
If you are a middle-aged, experienced adult looking for other income streams to replace your working income, you can consider putting your money into stocks that pay regular dividends. With a substantial capital, the dividends paid out may be enough to cover part, if not the entire recurring expenses that you make every month. A $500,000 portfolio with a 3% dividend yield will give you $15,000 per year – which is $1250 a month that can pay for your phone bills, utilities and other fixed expenses that you incur every month.
My personal opinion
Being in my 20s, I have the greatest advantage in investing – Time. I have the time to nurture the chicks into beautiful, fat chickens that I can sell at higher prices. I am more inclined in investing in stocks that will give me high capital gains as each stock is actually a business. Businesses grow and expand over time – like how Apple has grown from a company with market capitalisation of $1.778 billion in 1993 to $607.27 billion today. These stocks will also reward me with dividends, which is like a bonus as I will not expect the dividends to matter as much.
A high dividend yield will not be substantial without a large enough capital. 3% on a $20,000 capital will only yield you $600 per year. I would rather focus my time and energy in growing my capital through capital appreciation. Once I have accumulated a large capital, perhaps the dividends will play a more important role in replacing my recurring expenses.
Let me know how you feel below!