Owning Stocks

One of the most useful ratios in looking at stocks is the earnings per share (EPS) ratio. It calculates the company's earnings, the portion of a company's profit allocated to each outstanding share of common stock. The calculation lets you see how much you benefit from holding each share. Here is the formula for calculating EPS:

EPS = (net income − preferred stock dividends) ÷ average number of common shares outstanding

The company's earnings are reported on its income statement as net income, so a shareholder could easily track earnings growth. However, EPS allows you to make a direct comparison to other stocks by putting the earnings on a per-share basis, creating a common denominator. Earnings per share should be compared over time and also compared to the EPS of other companies.

When a stock pays a dividend, that dividend is income for the shareholder. Investors concerned with the cash flows provided by an equity investment look at dividends per share or DPS as a measure of the company's ability and willingness to pay a dividend.

DPS = common stock dividends ÷ average number of common shares outstanding

Another measure of the stock's usefulness in providing dividends is the dividend yield, which calculates the dividend as a percentage of the stock price. It is a measure of the dividend's role as a return on investment: for every dollar invested in the stock, how much is returned as a dividend, or actual cash payback? An investor concerned about cash flow returns can compare companies' dividend yields.

dividend yield = dividend per share (in dollars) ÷ price per share (in dollars)

For example, Microsoft, Inc., has a share price of around $24, pays an annual dividend of $4.68 billion, and has about nine billion shares outstanding; for the past year, it shows earnings of $15.3 billion. Assuming it has not issued preferred stock and so pays no preferred stock dividends,

EPS = 15.3 billion/9 billion = $1.70
DPS = 4.68 billion/9 billion = $0.52
dividend yield = 0.52/24 = 2.1667%

Microsoft earned $15.3 billion, or $1.70 for each share of stock held by stockholders, from which $0.52 is actually paid out to shareholders. So if you buy a share of Microsoft by investing $24, the cash return provided to you by the company's dividend is 2.1667 percent.

Earnings are either paid out as dividends or are retained by the company as capital. That capital is used by the company to finance operations, capital investments such as new assets for expansion and growth or repayment of debt.

The dividend is the return on investment that comes as cash while you own the stock. Some investors see the dividend as a more valuable form of return than the earnings that are retained as capital by the company. It is more liquid, since it comes in cash and comes sooner than the gain that may be realized when the stock is sold (more valuable because time affects value). It is the "bird in the hand," perhaps less risky than waiting for the eventual gain from the company's retained earnings.

Some investors see a high dividend as a sign of the company's strength, indicative of its ability to raise ample capital through earnings. Dividends are a sign that the company can earn more capital than it needs to finance operations, make capital investments, or repay debt. Thus, dividends are capital that can be spared from use by the company and given back to investors.

Other investors see a high dividend as a sign of weakness, indicative of a company that cannot grow because it is not putting enough capital into expansion and growth or into satisfying creditors. This may be because it is a mature company operating in saturated markets, a company stifled by competition, or a company without the creative resources to explore new ventures.

As an investor, you need to look at dividends in the context of the company and your own income needs.