The analysis of potential rate of return on a stock investment should be of primary interest before buying an individual companies stock.The determination of rate of return on a stock investment is made up of two components.In addition, the tax effect of the two components needs to be considered so the true after tax rate of return can be computed.The length of time that the stock is held can also impact the tax burden imposed on a stock investment.
The fist component of rate of return is the dividend rate.This is simply the amount of dividend paid on an annual basis divided by the amount paid for the stock.For example, if a share of stock is purchased for $100 and the stock pays and annual dividend of $10 the rate of return for the dividend is 10%.If taxes are paid at a 15% rate on the dividend then the actual after tax rate of return on the dividend is 8.5% ($10-($10*.15)/$100).
An investor interested in dividend payment should review the history of dividend payouts made by the company the investor is interested in order to determine the company’s dividend activity.The investor should also consider the type of company they are buying the stock of.Blue chip type companies that have regular and steadier profits more often pay a regular dividend to shareholders vs. a start up growth company that may be more interested in investing in growth then paying dividends to shareholders.
The second component of rate of return, and often the greatest part of rate of return is the capital appreciation on the stock.This is the amount of growth in price of the stock at the time of disposition of the stock over the original price paid for the stock.For example, if a share of stock is purchased for $100 and held for four years then sold for $175 the rate if returns is 75%, or 18.75% per year for the four year period.Assuming a 15% tax rate, the actual rate of return is 56.25% or 14.06% per year.If the company paid its dividend of $10 per share each of those years the combined after tax rate of return for the four year period would be 22.56%.
The rate of return on stock is actually more complex then the outline above but the illustrations are valid for a general discussion of rate of return on stock investments.However, in order to determine the potential for a desired rate of return on a stock investment the investor should consider other factors.Analyzing historical financial records of the company is the best place to start.Review of the income statements, balance sheets and statements of cash flow will provide key data to make intelligent determination of prior rates of returns on hypothetical investments.Of course, the history of the stock price will reveal trends and increased or decreased of stock over time.Current price to earning ration-the number of times the current market price of the stock divided into the company’s current earnings- is also a key indicator of potential up swing in price or downswing if the stock is over priced.Another great tool for today’s investor is the ready availability of analysis and opinions of other financial analysts view of the company’s earnings and growth potential.
All that said, investing in individual stocks is a risky business and an investor should take care to perform all the due diligence they can and then be prepared for volatility in the ups and down of the stock market and their own investments in various stocks.