Dividends – Return of Capital or Return on Capital?

Return of Capital vs Return On Capital

The difference between Return OF Capital and Return ON Capital.

First, let me quote Investopedia on Return of Capital:
A return from an investment that is not considered income. The return of capital is when some or all of the money an investor has in an investment is paid back to him or her, thus decreasing the value of the investment.

I’ve always thought that this applies more towards investment in businesses and properties, but upon further research, found that it applies to investments in stocks as well.

Dividends - Return of or on Capital

Photo source: dilbert.com

A return on your capital is simply a return on investment (ROI). You invest in a venture that produces a return, and that return is your ROI. It doesn’t matter if this investment produces income or simply appreciates in price. Let’s say you buy a stock that pays no dividend:

You pay RM1,000 for 10 shares of ABC Company at RM100 per share. A year later you sell your 10 shares for RM1,300. So the RM300 profit from the sale is your ROI. That’s a 30% return over the course of one year, which isn’t bad at all. Repeat that over and over again and you should do well.

Now, that scenario worked out pretty well. You likely had to stomach some ups and downs in the meanwhile, but all of your initial capital was returned to you, with a nice profit to boot.

That’s nice and all, but what happens when that asset doesn’t appreciate?

Let’s say you bought those same 10 shares (RM100 per share) of ABC Company for RM1,000, but a year later the Market plays his hand and those same 10 shares are now worth only RM700. You decide to sell on the news as the fundamentals have changed and you net a (RM300) loss on your investment. So you just took a 30% loss, meaning your ROI is a whooping -30%. You not only didn’t receive a profit, but you also took a loss on some of your capital. The capital you now have to reinvest elsewhere is smaller.



Photo source: pencilreturns.wordpress.com

Stocks that do not pay any dividends means your returns are totally at the mercy of the Market. I like to say dividends act as a kind of “buffer” between the market and your capital, and that’s because dividends flow directly from a company to you as a shareholder. They bypass the stock market altogether, and so that’s why you’ve got this interesting relationship going on where they function as both ROI, but also a return of your capital.

When you invest in a company that pays a dividend you’re receiving capital directly from the company. No matter what happens to the company’s stock price, that company is returning your capital. Slowly the capital you initially invested with the company is being directly returned to you in the form of regular dividend payments. So the share price may oscillate wildly affecting the eventual outcome of your ROI (if you ever sell), but your risk is being reduced one dividend check at a time because the capital you initially invested is slowly being returned to you. Eventually, if you hold on to the investment long enough and the company continues to pay dividends during that time frame, all of your capital will be returned to you, meaning any share price appreciation comes with essentially no risk on your part.

Even while dividends do affect your total return as they’re added on to any capital gains you may or may not receive, they also function as a return of your capital as a company you buy shares in sends you regular dividend payments.

So let’s get back to that earlier example, using the first scenario. This time, ABC Company pays a RM3.00/year dividend per share (3% yield).

In the first circumstance, you seen the share price appreciate from RM100 to RM130, but now you also collected RM3.00 per share in the form of a dividend. So your ROI was boosted slightly to 33% – 30% from capital gains and 3% from the dividend. In this scenario, you collected RM3.00 per share directly from the company and RM30.00 per share in capital gains. So not only are you left with RM1,330 when all is said and done in terms of your total return, but the RM30 you received directly from the company means the capital you had at risk, even if the company went bankrupt, is only RM970.

Real-Life Example

Dividend Magic

Enough with the hypothetical stuff, let me give you a real example from my own personal portfolio. For this, I will utilize my investment in IGB REIT and present to you how it has fared so far in the year 2015.

Total initial investment: RM20,030.56
Current Value : RM19,760.00
Capital loss : RM270.56 (-1.35%)

However, I’ve received a total of RM612.56 in dividends for the year 2015. This reduces my capital invested to RM19,418.00. Reversing my position from a loss of -1.35% to a gain of 3.15%.

But there is also a return OF my capital.

See, no matter what happens to IGB REIT from here on out, the capital I have at risk right now is only RM19,418.00, and that’s because IGB REIT has sent me cheques that total up to RM612.56. It doesn’t matter what the Market might think of the company and its future prospects, the business itself has sent me capital. Eventually, if I hold the position long enough and they continue paying dividends, IGB REIT will send me so many dividend checks that they will add up to more than I initially invested in the company. At that point, my capital on the line is essentially NIL. The company could go bust at that point, and I still would have technically lost nothing. In fact, it’s quite possible with a business that pays you dividends long enough that even if it goes bankrupt and you hold all the way through bankruptcy (an unlikely scenario) you would still actually end up with a positive return. Imagine that!

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