9. What is Dividend and Capital Gain?

You have been reading a lot about the stock market and stock trading in Pakistan. You must be wondering what’s in it for you? Well, you don’t have to give away your money to corporations for free! There are two types of returns that you can get when investing in the Pakistan Stock Market (PSX) i.e. Dividends and Capital Gains.

9.1. Dividends

Suppose Jahan runs a small-scale hotel called ‘Hotel Z’ in Lahore. The hotel has 20 rooms, a restaurant and a parking space that can accommodate 30 cars. He employs 100 people. Hotel Z is a publicly listed company on the Pakistan Stock Exchange and has 100 shares outstanding. Since he made Hotel Z public in 2015, he has been able to increase the number of rooms from 5 to 20 and invest in social media marketing. This has helped his hotel grow and attract numerous visitors over the past 3 years.

Hotel Z earned Rs. 10,000 in July 2018. Jahan thinks he should give something back to his valued shareholders. However, he also wants to invest at least Rs. 5000 in improving the quality of service offered in his hotel.

Finally, Jahan decides to keep Rs. 8,000 for investing in service quality and give away Rs. 2000 to his shareholders. The amount from the earnings that Jahan decides to give away to shareholders is the ‘dividend.’

When a company distributes a portion of its earning to shareholders in the form of cash or stock, it’s called a dividend.

9.1.1. Dividend Payout Ratio

Dividend Payout ratio is simply the portion of your earnings that you give away as ‘dividends.’ In this case, Hotel Z earned Rs. 10,000 and Jahan decided to give away Rs. 2000 as dividends to 100 shareholders. The Dividend Payout Ratio comes out to be 20% and each shareholder gets Rs.20.

Retained Earnings are the proportion of earnings that isn’t given away as dividend and is retained for investment for future growth of the firm.

Investors may rely on dividends as a source of income. Suppose an investor is retired and he bought 100 shares of a corporation 10 years ago. The company has announced to offer a dividend of PKR 2 per share each quarter. This implies that the investor can enjoy an income of PKR 200 four times a year without trading further.  

However, it is important to note that a company is not obligated to distribute dividends to its shareholders. The firm can simply choose to invest excess cashflows for expansion and future growth.

9.2. Capital Gain

Suppose Ali bought 200 shares of Jahan’s Hotel Z corporation at Rs. 100/share on December 31st, 2017. In total, he paid Rs. 20,000.

On July 20th, 2018, the price of Hotel Z shares has risen to Rs. 110/share. Ali sells 50 shares and gets Rs. 5,500. Compared to the cost of 50 shares i.e. Rs. 5,000, Ali got Rs. 5,500 after selling them. The additional amount of Rs. 500 earned on selling the shares is called ‘Capital Gain.’

On November 20th, 2018, Ali decides to sell rest of the 50 shares. Unfortunately, the price of Hotel Z corporation shares has dropped to Rs. 90/share. Compared to the purchase price of 50 shares i.e. Rs. 5,000, Ali would be able to get only Rs. 4,500 if he decides to sell the shares on November 20th, 2018. The loss of Rs. 500 on selling the shares is called ‘Capital Loss.’

Capital Gains or Losses are applicable to all assets and not just stocks. If you sell your house for more than it cost you, it would also be called Capital Gain.

9.3. Total Return

In order to calculate Total Return on investment in Stocks, investors need to determine their evaluation period. Let’s suppose the evaluation period is from 30th June, 2017 to 30th June, 2018 i.e. one year. Now consider the following assumptions regarding Jahan’s Hotel Z Corporation:

  • Ahmad is an investor who bought 100 shares of Hotel Z on 30th June, 2017. The purchase price was Rs. 1,500 per share.
  • Ahmad’s Investment Horizon or Evaluation Period is 1 year.
  • Ahmad earned a Dividend of Rs. 4/share during this horizon.
  • Ahmad sold his shares on 30th June, 2018 for Rs. 2,000 per share.

Total Return is simply the sum of Dividend and Capital Gains. Based on above mentioned assumptions:

  • Dividend Return: Ahmad earned Rs. 400 as Dividends during this evaluation period.
  • Capital Gains: The purchase price for 100 shares was Rs. 150,000. Ahmad sold them for Rs. 200,000. His gain was Rs. 50,000 over a period of one year.
  • Total Return: Ahmad’s Total Return comes out to be Rs. 50,400. The formula to calculate Total Return in percentage terms is:

$$(\text{Price per share at the end of Evaluation period} - \text{Purchase Price per Share}) + \text{Dividends} \over \text{Purchase Price per Share}$$

  • Based on above mentioned formula, the Total Return in percentage terms comes out to be
    $$ {2000 - 1500 + 400 \over 1500} = \text{33.6%} $$