Understanding the Wealth Flow of Stock Investments

Because once again, it is not good enough to measure in dollars.

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This writing assumes that you have read my prior one, “Understanding the Wealth Flow of Real Estate Investments”, and thus given your understanding of the wealth flow involved in real estate investments, let us see how this translates to owning shares of stock of Z Corp.

In year 2020, at $1,000 per share you buy 100 shares of Z Corp stock for $100,000. Ten years later, thanks to an increase in the price per share of Z Corp, you sell it all for $150,000.

On the surface it appears that you made a profit of $50,000, a ten-year 50% dollar ROI on your original investment of $100,000. But how much wealth did you make? Was the wealth flow positive or negative? What is the more important wealth ROI?

Can use the same table as before, with the annual inflation rate fixed at 3%:

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The amount of wealth required to purchase the stock in 2020 is $(2020)100,000, and thanks to inflation, in year 2030 this same amount of wealth will be stored in $(2030)134,390.

The pre-tax amount of wealth earned by the sale of the stock is:

$(2030)150,000 — $(2030)134,390 = $(2030)15,610

With the pre-tax ten-year wealth ROI being:

$(2030)15,610/$(2030)134,390 = 11.6%

As with real estate, earning $50,000 on the sale of an asset in any year is usually a taxable event, so assuming no deductions and a 25% income tax on your dollar gain, the income from this sale will be reduced by $12,500.

Which means that the after-tax amount of wealth earned from the sale of the stock is:

$(2030)150,000 — $(2030)12,500 — $(2030)134,390 = $(2030)3,110.

Again, almost break even in terms of wealth flow, with the wealth ROI approaching zero. But good news! Turns out that most public corporations issue this thing called a dividend, a periodic cash disbursement to shareholders. Kind of like rent. Meaning that the amount of money you received over the ten year span is probably greater than $50K.

The condo the rent was fixed at $800/month, but do not expect such consistency for a dividend. This requires some explaining as to what a dividend is.

A “dividend” is cash distributed from a corporation to the shareholders, usually quarterly, but in this example will be annually. Dividing the dividend by the number of shares yields the “Dividend per Share”, or the “Dividend Rate”.

Dividing the Dividend Rate by the price you previously paid for your shares yields the “Dividend Yield” for your holdings, which is probably different from the published Dividend Yield, which is the Dividend Rate divided by the market price per share on the day the dividend was issued.

Let us analyze the wealth flow of ten years’ worth of dividends, given the same 3% rate of inflation. Will also assume that Z Corp is growing, as reflected in the gradually increasing stock price, as determined by the market.

Perhaps in response to this increasing stock price, or perhaps due to higher profit margins, Z Corp gradually increases the Dividend Rate. It is their choice to do so.

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But as you know, we must account for inflation, so will convert the Dividend Rate into 2020 dollars, and then multiply that result by 100 (the number of shares you hold), to compute your received dividend, your annual “rent”, converted into 2020 dollars.

Converting the 2020 dollars into 2030 dollar, $(2020)22,436 = $(2030)30,064

And will once again assume a 25% tax on earnings, resulting in a tax bill of $(2030)7,516

So can now compute your net after-tax wealth earned:

$(2030)150,000 — $(2030)12,500 + $(2030)30,064 — $(2030)7,516 — $(2030)134,390 = $(2030)25,658

Yielding a ten-year wealth ROI of 25,658/134,390 = 19%, much better than the barely breaking even ROI without including the dividend.

Like rent, dividends are a good thing for investors. But unlike the well-understood rent, dividends are the subject of much confusion and debate. Or just entirely ignored.

Dividends are a funny thing, a corporation voluntarily deciding to give some of its hard-earned cash to its greedy shareholders. Why would they do such a thing? Why not instead pay the employees more, acquire another company, or invest in some more R&D?

Good questions, with the answer has something to do with another question, namely, “why do stocks have any value at all?”

Down the rabbit hole we go.

Dividends usually take the form of a consistent and/or predicable Dividend Rate. Corporations could in theory issue a consistent and predictable Dividend Yield, but due the volatility of the stock price, this is difficult if not impossible to achieve. So, a Dividend Rate it is, leaving it the investors to convert it to its corresponding Dividend Yield.

The Dividend Yield is a useful metric for investors, helpful in comparing one investment opportunity with another. Do you invest in a bond that pays an annual 3% coupon, or in a stock whose most recent dividend equated to a 2% Dividend Yield?

Z Corp could have kept its Dividend Rate fixed at $20/share through year 2030, but with the higher share price of $1,500, the Dividend Yield would have dropped to 1.33%. Perhaps not such an interesting investment anymore as compared to other investment opportunities. It could be argued that if Z Corp failed to increase its Dividend Rate over time, investor demand for the stock would decline, eventually lowering the share price.

Which is perhaps why companies tend to gradually increase the Dividend Rate as their stock price increases, which results in stabilizing the Dividend Yield, keeping it competitive with other investment choices. Which in turn can be argued stabilizes the share price by maintaining investor demand for the stock.

The counterargument being that the issuance of a dividend itself ought to depress the share price…

Consider this. Assume that in year 2020 Z Corp has 10,000 issued shares. At $1,000 per share, this gives Z Corp a “market cap”, or a “book value”, of $10 million (10,000 x $1,000). When they issue a 2020 dividend of $20/share, this means that $200,000 of cash departed the company, which in theory ought to reduce the book value to $9.8M. Which in turn ought to reduce the share price to $980.

In theory.

The problem is that there are many other forces of supply and demand acting upon the stock price, one of them of course being the increased demand for the stock because it pays this very dividend!

And it is very unclear as to how accurate the market cap is, in terms of representing the true value of a company. The bottom line is that on the day a company is purchased, we know exactly how much it is worth, in between those events, it is just collective opinion.

Another common argument against dividends is that this $200,000 would have been “better spent” reinvesting into the company, accelerating future growth, etc., all allowing for even a greater future value. Which explains why most corporations that are in early high-growth stage do not issue a dividend, they need that cash to grow.

And yet another argument is that dividends (and related buybacks) unfairly rewards the wealthy investors at the expense of the employees, who do not receive a raise.

Given all this, why do corporations issue dividends? Why not instead just keep re-investing in the company, accelerating growth, leading to greater revenues, profits, etc.? Have not fast-growing companies such as Amazon and Tesla proven that a high stock valuation can be achieved without issuing dividends?

They have, at least in the relative short term (years, not decades).

But what about the long term? For how long can Amazon and Telsa avoid paying a dividend? Why should they ever pay a dividend? The truth is that if investor demand continues to exceed supply, pushing the price of the stock up, they probably do not have to.

But how long can this continue, demand exceeding supply? Why are investors buying shares of Tesla and Amazon today, instead of investing elsewhere?

One answer is that long term investors are counting on a future profits and dividends, and they want to lock in a good future Dividend Yield.

The other answer is that without a dividend, investors are simply hoping to sell their share in the future at a higher price, to the next generation of speculators.

Which by itself is kind of like investing in tulips in the 1600’s, and only works if the stock price continues to rise, forever and ever.

But this is not a fairy tale, and history tells us that corporations have a finite lifespan thanks to agile startups, competition and disruptive technology induced change. At a minimum, they do not dominate the market forever. At some point corporations peak in size, and then decline, as will their inflation-corrected stock price.

When this happens, the speculation party is over, and demand for the stock will plummet unless the corporation is still profitable, and elects to issue a dividend, rewarding those earlier investors who still own shares.

Let us say that the company does not issue a dividend, and the stock plummets. What exactly is the problem, other than some wealthy investors being less wealthy. Why do public corporations care about the price of their stock?

One reason is that corporations always have the option of raising funds by creating and selling shares on the open market. The higher the price per share, the more funds they can raise in exchange for a percentage of the company. This is one of the reasons for being a public corporation.

The other reason being that a corporation is owned by the shareholders, and the shareholders prefer a positive wealth ROI, whether it be via a higher stock price or a dividend. If the stock price starts decreasing, you can assume that the owners of the company might decide it is high time for a dividend.

So, at some point, a successful and profitable corporation will probably eventually return wealth to the shareholders, whether it be in the form of a dividend or a stock buyback, because that is its destiny, as enforced by the shareholders, the owners. Preferably this will be done before the corporation is in decline (i.e., the swallowing crevice in the earth).

If Amazon and Tesla fail to return wealth to the investors at some later date when hyper-growth is no longer possible, but profits still are, this will have been nothing but a high stakes game of chicken / musical chairs for the shareholders. Not quite a Ponzi scheme as there were no representations, but many investors will lose wealth during the decline.

Hopefully, such successful corporations will choose to return wealth to the investors before the decline. If many fail to do so, then future investors might be discouraged from investing in stocks at all, pushing down the price of all stocks, and depressing the chances of future startups to raise needed funds.

One final comparison with real estate:

With the condo, it was pointed out that the price increase was due to a general increase in the price of land, that it did not have much to do with your individual condo. A quite different situation with stock, where it is the performance of the individual company itself that largely influences its share price. Which introduces a much greater degree of volatility compared to the usually slow changing price of real estate. A given stock price can increase 10X in a single year or can drop to zero in the event of bankruptcy.

Thus, the thrill of stock ownership.

What can be concluded from your trip down the rabbit hole of stock investing?

Unlike real estate, you cannot simply invest into a handful of companies and then passively collect dividends for infinity, or the rest of your life, whatever comes first. You must be nimble, selling the stock of companies prior to their decline, reinvesting in the next generation of up-and-coming startups.

Stop focusing on just the price of stocks and do take into account inflation and the Dividend Yield. Locking in a good Dividend Yield and ignoring price volatility will prevent you from euphoric buying when the price is high and panic selling when the price is low.

Want to learn more?

www.WTHisAnEconomy.com

Eric Johnson is a husband, father, engineer, pilot, surfer, investor and amateur astronomer who reads a lot of books on economics.

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