Investing Archives

May

2025

What Do Investment Bankers Do?

By Rebecca Lake | Growing Wealth, invest, Investing | Comments Off

Investment banking is a specialized area of the financial services industry that focuses on aiding governments, corporations, and other entities to raise capital and complete mergers and acquisitions. The term “investment banker” refers to an individual who works for an investment bank that offers these services.

Investment banking is typically considered to be a prestigious career, and becoming an investment banker can be lucrative for those willing to complete the necessary education and training.

Key Points

• Investment bankers do a number of things, such as raising capital through initial public offerings, bond issuance, and equity financing.

• Investment bankers are also known for assisting in mergers and acquisitions for companies.

• They also offer financial advisory services to clients.

• Conducting investment research for informed decisions is another key component of an investment banker’s job description.

• Investment bankers also manage asset investments for optimal returns.

What Is an Investment Banker?

Investment bankers work for investment banks, which are effectively middlemen between entities that need capital and entities that provide it. In simpler terms, investment bankers help their clients to expand and grow their businesses or operations.

Another way to think of an investment banker is as a financial advisor to governments, corporations, and other businesses. As part of their professional duties, they may guide clients in making financial decisions that directly or indirectly affect their bottom line.

Investment bankers are most often associated with Wall Street, though they work in cities throughout the world. Some of the largest investment banks in the United States include Goldman Sachs & Co., Morgan Stanley, J.P. Morgan, Bank of America Merrill Lynch, and Blackstone.

💡 Quick Tip: All investments come with some degree of risk — and some are riskier than others. Before investing online, decide on your investment goals and how much risk you want to take.

What Do Investment Bankers Do?

Investment bankers play an important role in helping companies achieve their financial goals. When a corporation is planning an upcoming expansion project, for instance, its board may turn to an investment bank for help. An investment banker can analyze the company’s financial situation to determine the best way to meet its needs.

In terms of the specific tasks an investment banker may carry out, that depends largely on the type of clients they work with.

Assisting With Initial Public Offerings

Investment bankers can play a critical role in helping clients secure capital. Depending on the client, this can be done through a variety of means, including the launch of an initial public offering (IPO).

An initial public offering, or IPO, allows private companies to offer shares of their stock to the public for the first time. The investment banker assists by creating a prospectus explaining the details of the IPO, marketing it to potential investors, and navigating Securities and Exchange Commission (SEC) compliance rules.

Investment bankers are often key to whether the company’s IPO is a success. They help determine the initial price of the offering, which is critical. Pricing too high could scare off investors, while going too low could undercut the capital their clients raise.

Bond Issuance

Government agencies and corporations often use bonds as a fundraising tool. For example, if a city government needs money to improve local roads, they might issue a municipal bond to fund the project. Investors purchase the bonds on the bond market, giving the government the capital it needs to complete the road updates. Investors can hold onto the bond and earn interest on it, or they can sell it to another investor.

As with an IPO, an investment banker’s role in issuing bonds may include preparing the bond issuance documents, setting a price, submitting it to the SEC for approval, and marketing the bond to investors to raise capital.

Equity and Debt Financing

Equity and debt financing are two other ways that companies can tap into funding. With equity financing, companies raise capital by selling an ownership share in the business. Venture capital and private equity are common examples of equity financing.

Debt financing involves taking out loans or lines of credit, without giving up ownership stakes. An investment banker can help companies assess which type of financing makes more sense for their business model, and help them work through the process of securing the funding.

For example, investment bankers may work with startups to pitch angel investors, while they might help more established companies compare and select loan options.

Mergers and Acquisitions

Another common task that investment bankers assist companies with is mergers and acquisitions. In a merger, two companies enter into an agreement to become a single business entity. Each company is treated as an equal in the transaction. An acquisition, on the other hand, involves one company purchasing another.

In either type of arrangement, companies may use investment bankers to oversee the process. This could involve negotiating the terms of a merger or acquisition and reporting the details of the transaction to the SEC to ensure compliance. When a company considers an acquisition, investment bankers can also help identify and vet potential targets.

Investing and Asset Management

While investment bankers’ duties primarily revolve around raising capital for their clients, there are other services they may perform. This can include things like:

• Investment research and analysis

• Buying and selling securities

• Offering advisory services

• Asset management

These services are similar to what a personal financial advisor might offer their clients.

💡 Quick Tip: Distributing your money across a range of assets — also known as diversification — can be beneficial for long-term investors. When you put your eggs in many baskets, it may be beneficial if a single asset class goes down.

How to Become an Investment Banker

If you’re interested in a career in investment banking, there are a few things to know.

In terms of education, a bachelor’s degree is typically a minimum requirement for most investment banker jobs. Though some investment banks may look for candidates that have earned a higher degree of education, such as an MBA or a graduate-level degree in finance.

Aside from education, there are certain skills that may help you be successful as an investment banker. Those include:

• Ability to perform under pressure

• Good communication skills

• Solid marketing skills

• Firm grasp of financial markets and modeling

• Strong attention to detail

Depending on your responsibilities, you may also need a securities license. That may include completing one or more of the following licensing exams:

• Series 7 General Securities Representative Qualification Examination (GS)

• Series 79 Investment Banking Representatives Exam

• Series 63 Uniform Securities Agent State Law Exam

Before you can take these exams, you first have to be employed and sponsored by a FINRA-member firm or other self-regulatory organization member.

Taking and passing the Securities Industries Essentials (SIE) Exam could help improve your chances of being hired as an intern or junior employee. That process begins early, with many banks hiring summer interns more than a year ahead of the start of the program.

How Much Do Investment Bankers Earn?

Investment bankers generally earn above-average salaries. Even at the entry level, it’s possible to make $100,000 or more, and salaries for top Wall Street bankers can easily range into the millions or tens of millions. But investment banking is one of the hardest jobs on Wall Street. So, if you’re not prepared to routinely work 100-hour weeks or constantly be on-call for your clients, it may not be the job for you.

The Takeaway

Investment bankers work primarily with institutional investors, governments, and corporations rather than individual investors. But you can still benefit from the work investment bankers do behind the scenes indirectly.

Investment bankers may work in a variety of roles, such as helping facilitate IPOs, or mergers and acquisitions. It can be a lucrative career path, too, but generally requires a graduate-level education, and additional licensing.

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FAQ

What is an investment banker?

An investment banker is a financial professional that works for an investment bank, and generally, helps their clients to expand and grow their businesses or operations.

What are some common things that investment bankers do?

Investment bankers do a number of things, including issuing bonds, facilitating initial public offerings, managing investors’ portfolios and assets, and more.

How much are investment bankers paid?

Careers in investment banking tend to be lucrative, with salaries typically in the six figures, and ranging well into the millions. It is, however, a difficult and time-intensive job, with some people working 80-, 90-, or even 100-hour weeks.

About the author

Rebecca Lake

Rebecca Lake has been a finance writer for nearly a decade, specializing in personal finance, investing, and small business. She is a contributor at Forbes Advisor, SmartAsset, Investopedia, The Balance, MyBankTracker, MoneyRates and CreditCards.com. Read full bio.

Photo credit: iStock/fizkes

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SOIN-Q225-057

May

2025

What Is Deflation and Why Does It Matter?

By Ashley Kilroy | Financial Independence, Growing Wealth, invest, Investing | Comments Off

Deflation is the opposite of inflation. It occurs when the prices consumers pay for goods and services go down. That means that consumers can purchase more with the same amount of money.

There are many factors that cause deflation, which happens when the supply of goods and services is higher than the demand for them. While deflation can have some benefits to consumers, it’s often a sign of trouble for the overall economy.

Key Points

• Deflation, marked by falling prices, can lead to economic stagnation and business closures.

• Government interventions, including fiscal and monetary policies, help combat deflation and stabilize the economy.

• Deflation often follows financial crises and is influenced by consumer confidence, technology, and lower production costs.

• Negative impacts include reduced business revenues, increased unemployment, and decreased consumer demand.

• The Great Depression exemplifies how deflation caused business failures and unprecedented unemployment.

What Happens During Deflation?

In addition to knowing what inflation is, it’s important to understand how it impacts the economy. In a deflationary economy, prices gradually drop and consumers can purchase more with their money. In other words, the value of a dollar rises when deflation happens.

It’s important not to confuse deflation with disinflation. Disinflation is simply inflation decelerating. For example, the annual inflation rate may change from 5% to 3%. This variation still means that inflation is present, just at a lower rate. By contrast, deflation lowers prices. So, instead of prices increasing 3%, they may drop in value by 2%.

Although it may seem advantageous for consumer purchasing power to increase, it can accompany a recession. When prices drop, consumers may delay purchases on the assumption that they can buy something later for a lower price. However, when consumers put less money into the economy, it results in less money for the service or product creators.

The combination of these two factors can yield higher unemployment and interest rates. Historically, after the financial crises of 1890, 1893, 1907, and the early-1930s, the United States saw deflationary periods follow.

How Is Deflation Measured?

Economists measure deflation the same way they measure inflation, by first gathering price data on goods and services. The Bureau of Economic Analysis (BEA) and the Bureau of Labor Statistics (BLS) record and monitor this type of data in the United States. They collect pricing information that they then put into buckets reflecting the types of goods and services consumers generally use.

While these buckets do not include every product and service, they offer a sample of items and services consumed. In the United States, economists incorporate these prices into an indicator known as the Consumer Price Index (CPI).

Then, economists can compare the CPI to previous years to determine whether the economy is experiencing inflation or deflation. For example, if the prices decrease in a period compared to the year before, the economy is experiencing deflation. On the other hand, if prices increase compared to the previous year, the economy is experiencing inflation.

What Causes Deflation?

Deflation comes from a swing in supply and demand. Typically, when demand dwindles and supply increases, prices drop. Factors that may contribute to this shift include:

Rising Interest rates

When the economy is expanding, the Federal Reserve may increase interest rates. When rates go up, consumers are less likely to spend their money and may keep more in high-interest savings accounts to capitalize on the increase in rates.

Also, the cost of borrowing increases with the rise of interest rates, further discouraging consumers from spending on large items.

Decline in Consumer Confidence

When the country is experiencing economic turbulence, like a recession, consumers spend less money. Because consumers tend to worry about the direction of the economy, they may want to keep more of their money in savings to protect their financial well-being.

Innovations in Technology

Technological innovation and process efficiency ultimately help lower prices while increasing supply. Some companies’ increase in productivity may have a small impact on the economy. While other industries, such as oil, can have a drastic impact on the economy as a whole.

Lower Production Costs

When the cost to produce certain items, such as oil, decreases, manufacturers may increase production. If demand for the product stagnates or decreases, they may then end up with excess supply. To sell the product, companies may drop prices to encourage consumer purchases.

Why Does Deflation Matter?

Although falling prices may seem advantageous when you need to purchase something, it’s not always a good sign for the economy. Many economists prefer slow and unwavering inflation. When prices continue to rise, consumers have an incentive to make purchases sooner, which further boosts the economy.

One of the most significant impacts of deflation is that it can take a toll on business revenues. When prices fall, businesses can’t make as much money.

The drop in business profits makes it challenging for companies to support their employees, leading to layoffs or pay cuts. When incomes go down, consumers spend less money. So deflation can create a domino effect impacting the economy at many different levels, including lower wages, increased unemployment, and falling demand.

Deflation During The Great Depression

The Great Depression is a significant example of the potential economic impact of a deflationary period. While the 1929 stock market crash and recession set this economic disaster off, deflation heavily contributed to it. The rapid decrease in demand along with cautious money hoarding led to falling prices for goods and services. Many companies couldn’t recover and shut down. This caused record-high unemployment in the United States, peaking at 25%, and in several other countries as well.

During this time, the economy continued to experience the negative feedback loop associated with deflation: cash shortages, falling prices, economic stagnation, and business shutdowns. While the United States has seen small episodes of deflationary periods since the Great Depression, it hasn’t seen anything as substantial as this event.

How to Manage Deflation

So, what can the government do to help regulate inflation? For starters, the Federal Reserve can lower interest rates to stimulate financial institutions to lend money. The Fed may also purchase Treasury securities back to increase liquidity that may help financial institutions loan funds. Those initiatives can increase the circulation of the money in the economy and boost spending.

Another way to manage deflation is with changes in fiscal policy, such as lowering taxes or providing stimulus funds. Putting more money in consumers’ pockets encourages an increase in spending. This, in turn, creates a chain effect that may increase demand, increase prices, and move the economy out of a deflationary period.

The Takeaway

Deflation refers to a period that can be thought of as the opposite of inflation. It occurs when the prices consumers pay for goods and services go down, which means that consumers can purchase more with the same amount of money.

When the economy is experiencing some turbulence, some investors may choose to keep their money in savings. On the other hand, other investors may see falling prices as an opportunity to purchase securities at a discount, either to hold or to sell when the economy recovers. Like any other investment strategy, investors must base their investment decisions on their personal preferences since there are no guaranteed results.

Opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.¹

About the author

Ashley Kilroy

Ashley Kilroy is a seasoned personal finance writer with 15 years of experience simplifying complex concepts for individuals seeking financial security. Her expertise has shined through in well-known publications like Rolling Stone, Forbes, SmartAsset, and Money Talks News. Read full bio.

Photo credit: iStock/eclipse_images

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SOIN-Q225-051

May

2025

Investing in Small-Cap Stocks

By Ashley Kilroy | Growing Wealth, invest, Investing, Terminology | Comments Off

Small-cap stocks are stocks in smaller companies, typically those worth between $250 million and $2 billion. Small-cap stocks often have high growth potential, which could make them an attractive investment. However, while these stocks may provide the opportunity to see higher returns over time, they also come with higher volatility and risk levels.

For investors considering adding small-cap stocks to their portfolios, it’s essential to understand how these stocks work and the advantages and disadvantages that come with this type of investment.

Key Points

• Small-cap stocks have a market capitalization of $250 million to $2 billion, offering significant growth potential.

• Higher risks and volatility are common due to less established business models and financial challenges.

• Limited analyst coverage can lead to undervaluation, presenting investment opportunities.

• Financial institutions may not heavily invest, affecting market liquidity and trading ease.

• Diversifying through mutual funds or ETFs can help mitigate risks and balance returns.

What Are Small-Cap Stocks?

Small-cap stocks are shares of companies with a market cap between $250 million and $2 billion, and are usually moderately young companies. Small-cap stocks typically have some growth potential, but they may not have a longstanding market history. Therefore, these stocks are considered to be riskier than mid-cap stocks or large cap stocks.

Understanding Market Capitalization

Market capitalization, or market cap, is a measure of an individual company’s value. The market cap represents the value of total outstanding shares. Investors can use this value to compare similar companies as well as consider future growth predictions.

To calculate a company’s market cap, multiply the total number of outstanding shares by the current share price. For example, let’s say a company has 15 million outstanding shares at a share price of $25 per share. Using this calculation, the company’s market cap would be $375 million.

Due to share price fluctuations, the market cap fluctuates over time. To find the number of outstanding shares, investors can review the “capital stock” numbers on a company’s balance sheet. This information is updated during the quarterly filings with the Securities and Exchange Commission (SEC).

Are Small-Cap Stocks a Good Investment?

Small-cap stocks may be a good investment as part of a diversified portfolio, but there are risks. The market cap of a company can give investors an idea of the risk and reward of purchasing individual stocks. Purchasing small-cap stocks may be riskier than buying stocks of larger companies because the companies are often still in growth mode. In addition, small-cap companies often have fewer resources than large-cap companies, and may have less access to liquidity.

Due to these factors, any market dip can negatively impact small-cap stocks. Conversely, smaller companies often have higher upside potential, and small-cap growth stocks may deliver higher returns than their peers. Still, investors who choose these investments may have to weather market volatility along the way to growth.

Pros of Investing in Small-Cap Stocks

There are several benefits to allocating some of your portfolio into small-cap stocks.

Growth Potential

When comparing large-cap stocks to small-cap stocks, small-cap stocks tend to have a higher growth potential over the long-term. For much of the stock market’s history, small-cap stocks had higher returns than large-cap stocks, and other asset classes.

This growth potential makes small-cap stocks an attractive investment choice for investors. They tend to perform particularly well after recessions, during periods of economic expansion.

They’re Often Undervalued

Analysts usually spend less time analyzing small-cap stocks, so they get less attention from investors, which can lead to lower demand — and lower prices. Therefore, investors may be able to leverage the inefficiencies of the market for potentially better returns.

Financial Institutions Don’t Increase Stock Prices

Specific regulations may not allow financial institutions such as hedge funds and mutual funds to heavily invest in small-cap stocks. Therefore, it’s unlikely that large investments from financial institutions will artificially increase the stock price.

Cons of Investing in Small-Cap Stocks

While small-cap stocks have their benefits, there are also several drawbacks that investors should consider.

High Risk

Investing in small-cap stocks tends to have significant risk for investors. Since they’re often younger companies, small-cap companies do not always have a time-tested business model. If the company’s management can not make appropriate adjustments to the business model, it may yield poor financial or operational results.

Also, because small-cap companies may lack the resources such as capital or access to financing that larger companies have, they may struggle to expand the business or fill in cash flow gaps, especially if the economic conditions tighten.

Research May Be Time-Consuming

Due to the limited availability of research and analysis done on small-cap stocks, investors may have to spend a significant amount of time researching each investment option.

Minimal Liquidity

Small-cap stocks tend to have less liquidity than large cap company stocks. Since there are fewer shares available, investors may not be able to purchase the stock. Conversely, investors may not be able to sell their shares at a reasonable price. The liquidity of small-cap stocks adds to the risk of investing in this type of stock.

How to Invest in Small-Cap Stocks

Investors can purchase small-cap stocks through a brokerage firm or an individual investment account. Since there’s often less public information available about small-cap stocks, investors must do their own due diligence in researching companies to understand their potential risks and returns.

Investors who don’t have the time or expertise to determine which individual small-cap stocks to buy can invest in small-cap companies by purchasing mutual funds or exchange-traded funds (ETFs) that track a broader range of small-cap indexes. Some funds may also have unique characteristics within them, such as growth- or value-oriented stocks.

Buying mutual funds and ETFs allow investors to pool funds with other investors to sell and buy buckets of market securities. This type of investing aims to mitigate risks by diversifying investments. Instead of investing in a single company, fund investors are purchasing shares in dozens or hundreds of companies. Investing in mutual funds and ETFs is more of a passive investment strategy that doesn’t require investors to make trades actively.

💡 Quick Tip: Are self directed brokerage accounts cost efficient? They can be, because they offer the convenience of being able to buy stocks online without using a traditional full-service broker (and the typical broker fees).

Diversifying With Small-Cap Stocks

Even though small-cap mutual funds and ETFs provide diversification within a specific asset class, investors can further reduce their risk exposure by expanding portfolio diversification into a broader mix of assets.

Depending on market conditions, different types of stocks may perform differently. The concept can apply to stocks of companies that vary in sizes. Depending on what the market is doing, small, medium, and large companies may either beat the market returns or underperform.

When diversifying a portfolio, investors may start by determining their investment goals, risk tolerance, and time horizon. Then, by assessing these factors, they can decide an appropriate asset allocation to determine the portfolio’s percentage that may include stocks. A typical example is a portfolio composed of 60% stocks and 40% bonds.

Investors use the same factors (time horizon, goals, and risk tolerance) to decide the mix of stocks that will go into the portfolio’s stock percentage portion. Then, as market fluctuations happen, allocations of the portfolio will perform inversely.

For instance, as small-cap stocks are rising, mid-cap stocks may fall. In this case, small-cap stock prices’ upward movement can offset the decrease in mid-cap stock prices, thus mitigating losses.

The Takeaway

Small-cap stocks are shares of companies with market caps ranging from $250 million to $2 billion. Although small-cap stocks have the potential for long-term growth, they tend to come with more risk. With this in mind, building a diversified portfolio with a broader range of investments can help minimize your risk exposure.

But, attempting to build an entire portfolio from scratch and keep it balanced can be time-consuming and a risky venture if you’re an average investor. Instead, many investors choose to get small-cap exposure by purchasing mutual funds and exchange-traded funds (ETFs), which mimic the returns of indices that track stocks meeting certain criteria.

Opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.¹

FAQ

What is a small-cap stock?

Small-cap stocks are shares of companies with market capitalizations between $250 million and $2 billion, making them relatively small.

What are some of the advantages to investing in small-cap stocks?

The primary advantages of investing in small-cap stocks are the potential for growth, share values tend to be relatively low, and share prices may not get pumped up due to large institutional investor activity.

What are the risks of investing in small-cap stocks?

Small-cap stocks tend to be riskier investments than some of their larger counterparts. They may take additional time to research and study, and they may also lack the same levels of liquidity as larger-cap stocks.

About the author

Ashley Kilroy

Photo credit: iStock/Erikona

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SOIN-Q225-055

May

2025

Opportunity Cost and Investments

By Brian Nibley | Growing Wealth, invest, Investing | Comments Off

The opportunity cost of an investment refers to the potential gain or loss incurred by not choosing to go with a different investment. Opportunity cost is a term or concept that doesn’t just apply to investing, and can be applied to other economic areas as well.

Investors at all income levels have a limited amount of funds to work with. And while some people are more risk-tolerant than others, considering the opportunity cost of choosing one investment over another will always be necessary.

Key Points

• Opportunity cost involves the potential gains lost by choosing one investment over another.

• The concept is theoretical and can be challenging to understand and apply.

• Staying out of the market can result in high opportunity costs.

• A simple formula can estimate opportunity cost: FO – CO, where FO is the return on the best foregone option, and CO is the return on the chosen option.

• Time and effort, known as sweat equity, are additional factors to consider in investment decisions.

Opportunity Cost vs Risk

As noted, the concept of opportunity cost can be applied to almost any situation, not just those relating to financial matters. As it relates to investing, it’s especially important to consider applicable risks. But opportunity costs and risk are two different, albeit related, things.

Failing to consider the potential risks of an investment when trying to calculate opportunity cost could lead to an “apples-and-oranges” type of comparison.

Consider this: Someone wants to figure out the opportunity cost of investing in a penny stock rather than buying a U.S. Treasury bond. The latter are less risky investments, being 100% backed by the U.S. government.

Penny stocks, on the other hand, carry a high amount of risk, being volatile and having a real possibility of going to zero if the underlying company goes bankrupt.

If an investor thinks about opportunity cost in this example, without factoring in risk, they will choose the penny stock every single time. And without considering the risks involved, doing so would make sense.

Less risky investments, like Treasuries, tend to come with low returns. But, again, they’re low-risk assets, so investors should likely anticipate their expected returns to be low, as they don’t generate big returns. While a riskier investment like a penny stock might yield big gains, it comes with significant risk, and could also yield large losses.

In effect, there’s a tradeoff and inverse relationship between risk and potential reward or returns. Investing in the penny stock risks losing capital, while investing in Treasuries risks losing the larger gains.

What Is Opportunity Cost When Evaluating Investments?

There are two main types of opportunity cost as it relates to financial decisions: Explicit opportunity cost, and implicit opportunity cost.

The first type, explicit opportunity cost, is easy to calculate because it involves the objective value that an investor sacrifices when making one investment decision instead of another. The second type, implicit opportunity cost, can be harder to calculate because it’s more subjective.

Implicit opportunity costs tend to involve resources and a lost opportunity to generate additional income rather than a direct cost.

For example, say someone owns a second home in the Hamptons. This person loves vacationing in the Hamptons so much that they choose not to rent out the home, foregoing the significant revenue that doing so might bring in. That lost revenue represents the implicit opportunity cost of using the home as a luxurious vacation destination rather than a rental property.

How to Calculate Opportunity Cost

It’s important to remember that any attempt at this kind of calculation will be somewhat of an estimation because it’s impossible to predict with 100% certainty. But, for the purposes of trying to calculate opportunity cost, it becomes necessary to make some related assumptions as to risk and reward.

When a skilled financial professional wants to determine how to calculate opportunity cost, they might use a complex mathematical formula called the Net Present Value (NPV) formula. This formula can be calculated in a spreadsheet and includes specific business factors like free cash flow, interest rates, and the number of periods in the future in which free cash flow will happen.

For most individual investors, an all-out calculation using the NPV formula might be going a little overboard. The effort required could be unnecessary, and investors may not always have access to the required information.

However, some simple arithmetic can often work, too. The only required knowledge for such a calculation will be what an investor sacrifices by making one decision rather than another.

A Simple Opportunity Cost Formula

An opportunity cost example equation would look like this:

Opportunity Cost = FO – CO

Where FO is equivalent to the return on the best foregone option, and CO is equivalent to the return on the chosen option. In other words, subtracting the amount of money made on a chosen investment from the amount of money that would have been made on the other, not chosen, investment.

Beyond that, it can also be worthwhile to take into consideration the variables of time and sweat equity. Sweat equity refers to the work that might be required to maintain something. Likewise, time refers to the time a particular economic decision will require.

For example, investors who tend to be more self-directed and choose to do their own research will likely want to pick each specific security in their portfolios and how much capital they want to allocate to each position. That research requires sweat equity, but could lead to higher returns if done well.

Other investors may choose a more passive investment style and either put all of their available capital in a single ETF or use a robo-advisor that chooses security allocations for them. This method minimizes sweat equity but could potentially see lower returns.

When it comes to the simple math, let’s say an investor really likes Restaurant X. She typically eats three Restaurant X meals each week, costing about $10 each, for a total of about $120 per month.

Our Restaurant X fan could decide to cook her own meals three nights a week, with an approximate cost of $60 per month. She then invests the extra $60 she has now saved.

The opportunity cost in this random example is missing out on the Restaurant X experience. The gain would be having a little extra cash to invest each month.

The Takeaway

Opportunity costs in investing refer to the potential gains given up in exchange for choosing one thing over another. It’s theoretical and hypothetical, and can be tricky to grasp, but is an important concept in investing. In the long run, the opportunity cost of choosing to stay out of the market tends to be high. Would-be investors might miss out on potential gains.

Without having money work for itself and earn interest, dividends, or capital gains, it’s very difficult to build long-term wealth. That said, there are many factors to take into consideration when investing, and for some, it may be best to seek the advice of a financial professional for some guidance.

Opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.¹

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SOIN-Q225-013

May

2025

How to Calculate a Dividend Payout Ratio

By Austin Kilham | Growing Wealth, invest, Investing | Comments Off

A dividend payout is the dividend amount a shareholder can expect, based on their number of shares. The dividend payout ratio is the ratio of total dividends paid to shareholders relative to the net income of the company.

Investors can use the dividend payout formula to gauge how much a company is paying to shareholders versus reinvesting in the company for growth, to pay off debt, and so on.

Some companies pay out some or all of their earnings as dividends; but some companies don’t make any dividend payments. If dividends are an important part of your investing strategy, you may also want to understand how different types of dividends are taxed.

Key Points

• Some companies pay dividends, a percentage of earnings, to shareholders.

• The dividend payout ratio is the amount of dividends relative to total net income.

• Knowing the dividend payout ratio can help investors gauge the overall health of a company.

• Dividend payout ratios vary widely by company. Some companies distribute some, all, or none of their earnings to shareholders.

• Ordinary dividends are taxed as income; qualified dividends are taxed as capital gains.

Understanding Dividends and How They Work

Before calculating potential dividends, investors will want to familiarize themselves with what dividends are.

A dividend is when a company periodically gives its shareholders a payment in cash, or additional shares of stock, or property. The size of that dividend payment depends on the company’s dividend yield and how many shares you own.

Many investors look to buy stock in companies that pay dividends as a way to generate regular income, in addition to stock price appreciation. A dividend investing strategy is one way many investors look to make money from stocks. Investors can take their dividend payments in cash or reinvest them into their stock holdings.

Not all companies pay dividends, and those that do tend to be large, established companies with predictable profits — blue-chip stocks, for example. If an investor owns a stock or fund that pays dividends, they can expect a regular payment from that company — typically, each quarter. Some companies may pay dividends more or less often.

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Pros and Cons of Investing in Dividend Stocks

Since dividend income can help augment investing returns, investing in dividend stocks — or stocks that tend to pay higher than average dividends — is popular among some investors. But engaging in a strategy of purchasing dividend stocks has its pros and cons.

The most obvious advantage is that investors will receive dividend payments and may also see stock appreciation from their holdings. Another benefit is that investors can set up their dividends to automatically reinvest, meaning that their holdings grow with no extra effort.

Potential drawbacks, however, are that dividend stocks may generate a higher tax burden, depending on the specific stocks. You’ll need to look more closely at whether your dividends are “ordinary” or “qualified,” and dig a little deeper into qualified dividend tax rates to get a better idea of what you might end up owing.

Also, stocks that pay higher dividends often don’t see as much appreciation as some other growth stocks — but investors do reap the benefit of a steady, if small, payout.

What Is the Dividend Payout Ratio?

The dividend payout ratio expresses the percentage of net income that a company pays to shareholders as dividends. Ratios vary widely by company. Some may pay out all of their net income, while others may hang on to a portion to reinvest in the company or pay off debt.

Generally speaking, a healthy range for the dividend payout ratio is from 35% to 55%. There are certain circumstances in which a lower ratio might make sense for a company.

For example, a relatively young company that plans to expand might reinvest a larger portion of its profits into growth. A company’s dividend ratio might be lower or higher than that range. It’s important to consider dividend payouts in the greater context of the company itself.

How to Calculate a Dividend Payout

Calculating your potential dividend payout is fairly simple: It requires that you know the dividend payout ratio formula, and simply plug in some numbers.

Dividend Payout Ratio Formula

The simplest dividend payout ratio formula divides the total annual dividends by net income, or earnings, from the same period. The equation looks like this:

Dividend payout ratio = Dividends paid / Net income

Again, calculating the payout ratio is only a matter of doing some plug-and-play with the appropriate figures.

Dividend Payout Ratio Calculation Example

Here’s an example of how to calculate dividend payout using the dividend payout ratio.

• If a company reported net income of $120 million and paid out a total of $50 million in dividends, the dividend payout ratio would be $50 million/$120 million, or about 42%. That means that the company retained about 58% of its profits.

Or, to plug those numbers into the formula, it would look like this:

~42% = 50,000,000 / 120,000,000

• An alternative dividend payout ratio calculation uses dividends per share and earnings per share as variables:

Dividend payout ratio = Dividends per share / Earnings per share

A third formula uses retention ratio, which tells us how much of a company’s profits are being retained for reinvestment, rather than paid out in dividends.

Dividend payout ratio = 1 – Retention ratio

• You can determine the retention ratio with the following formula:

Retention ratio = (Net income – Dividends paid) / Net income

You can find figures including total dividends paid and a company’s net income in a company’s financial statements, such as its earnings report or annual report.

Why Does the Dividend Payout Ratio Matter?

Dividend stocks often play an important part in individuals’ investment strategies. As noted, dividends are one of the primary ways stock holdings earn money — investors also earn money on stocks by selling holdings that have appreciated in value.

Investors may choose to automatically reinvest the dividends they do earn, increasing the size of their holdings, and therefore, potentially earning even more dividends over time. This can often be done through a dividend reinvestment plan.

But it’s important to be able to know what the ratio results are telling you so that you can make wise decisions related to your investments.

Interpreting Dividend Payout Ratio Results

Learning how to calculate dividend payout and use the payout ratio is one thing. But what does it all mean?

On a basic level, the dividend payout ratio can help investors gain insight into the health of dividend stocks. For instance, a higher ratio indicates that a company is paying out more of its profits as dividends, and this may be a sign that it is established — or not necessarily looking to expand in the near future.

On the other hand, it could also indicate that a company isn’t investing enough in its own growth.

Lower ratios may mean a company is retaining a higher percentage of its earnings to expand its operations or fund research and development, for example. These stocks may still be a good bet, since these activities may help drive up share price or lead to large dividends in the future.

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Dividend Sustainability

Paying attention to trends in dividend payout ratios can help you determine a dividend’s sustainability — or the likelihood a company will continue to pay dividends of a certain size in the future. For example, a steadily rising dividend payout ratio could indicate that a company is on a stable path, while a sudden jump to a higher payout ratio might be harder for a company to sustain.

That’s knowledge that may be put to use when trying to manage your portfolio.

It’s also worth noting that there can be dividend payout ratios that are more than 100%. That means the company is paying out more money in dividends than it is earning — something no company can do for very long. While they may ride out a bad year, they may also have to lower their dividends, or suspend them entirely, if this trend continues.

Dividend Payout Ratio vs Dividend Yield

The dividend yield is the ratio of a stock’s dividend per share to the stock’s current price:

Dividend yield = Annual dividend per share/Current stock price

As an example, if a stock costs $100 and pays an annual dividend of $7, the dividend yield will be $7/$100, or 7%.

Like the dividend payout ratio, dividend yield is a metric investors can use when comparing stocks to understand the health of a company. For example, high dividend yields might be a result of a quickly dropping share price, which may indicate that a stock is in trouble. Dividend yield can also help investors understand whether a stock is valued well and whether it will meet the investor’s income needs or fit with their overall investing strategy.

Dividend yield can also help investors understand whether a stock is valued well and whether it will meet the investor’s income needs or fit with their overall investing strategy.

Dividend Payout Ratio vs Retention Ratio

As discussed, the retention ratio tells investors how much of a company’s profits are being retained to be reinvested, rather than used to pay investors dividends. The formula looks like this:

Retention ratio = (Net income – Dividends paid) / Net income

If we use the same numbers from our initial example, the formula would look like this:

(120,000,000 – 50,000,000) / 120,000,000 = ~58%

This can be used much in the same way that the dividend payout ratio can, as it calculates the other side of the equation — how much a company is retaining, rather than paying out. In other words, if you can find one, you can easily find the other.

The Takeaway

The dividend payout ratio is a calculation that tells investors how much a company pays out in dividends to investors. Since dividend stocks can be an important component of an investment strategy, this can be useful information to investors who are trying to fine-tune their strategies, especially since different types of dividends have different tax implications.

In addition, the dividend payout ratio can help investors evaluate stocks that pay dividends, often providing clues about company health and long-term sustainability. It’s different from other ratios, like the retention ratio or the dividend yield.

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FAQ

How do you calculate your dividend payment?

To calculate your exact dividend payment, you’d need to know how many shares you own, a company’s net income, and the number of total outstanding shares. From there, you can calculate dividend per share, and multiply it by the number of shares you own.

Are dividends taxed?

Yes, dividends are taxed, as the IRS considers them a form of income. There may be some slight differences in how they’re taxed, but even if you reinvest your dividend income back into a company, you’ll still generate a tax liability by receiving dividend income.

What is a good dividend payout ratio?

Dividend payout ratios can range from 0% to 100% (or more, in some cases). A healthy range is generally considered to be between 35% to 55%. This can indicate a sustainable payout for a company, and provide confidence that cash flow is being distributed across priorities.

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Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

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Why Does the Dividend Payout Ratio Matter?

Interpreting Dividend Payout Ratio Results

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Dividend Payout Ratio vs Dividend Yield

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