How do stocks work and how do you make a profit off of it??



How do stocks work and how do you make a profit off of it??

In: Economics

Stock is a claim to ownership of a small part of everything the firm owns. Things, generally speaking, have value.

If a firm seems like it’s growing a lot, selling more stuff and the like, people may be willing to pay more for a share of ownership in the company than they did before this growth became clear. If you bought the stock earlier you may be able to sell it now for a profit.

In a nutshell, you can earn money by buying something, waiting until it becomes more valuable, and then selling it.

Shares of stock are tiny fractions of ownership in a company. The two main ways to make money are “buy low, sell high” and dividends. The first means that you buy shares, hope they increase in value and then sell them. So you buy shares of Apple at $50 and when it’s increased to $150 you decide to sell and buy Tesla shares. Dividends are quarterly payments from company profits that some companies make. They are typically about 1-3% of share price but not all companies pay them, choosing to reinvest profits into growing the business. There are also companies who pay out larger dividends because they are stable, slower growth companies (like utilities).

There’s 2 ways to make money off of stocks. Dividends and buying low/selling high.

Dividends are money the company decides it can share with their shareholders. This is basically the profits that they decide not to reinvest and instead send to their shareholders.

Buying low/selling high is generally seen as the “real” way to make money in the stock market. In general, if the company is doing well, their stock price will rise much faster than whatever they pay out in dividends.

That second aspect leads to an interesting phenomena. You know how CEO’s are generally paid in stock? Well, paying them in stock adds shares in the company to the market. This should cause stock prices to go down because there’s a larger supply. But that generally doesn’t happen for companies that are doing well because of investor demand for the shares. In reality when CEOs are paid in stocks, the shareholders are actually paying their salary. Not the company itself. This is why it’s such a common practice, companies are offloading the cost of their CEO to the shareholders.

Pokemon/Yu-Gi-Oh Cards are Assets. You buy and sell cards from others. The money value of the cards depends on the demand and supply of the individual cards. The supply of the cards are fixed by the drop rated. The demand of the card depends on the meta.

Stocks are Assets. You buy and sell stocks on the market through a broker. The money value of the stock depends on the demand and supply of the individual stocks. The supply of the stock are fixed by how much of the stock has been released on the market. The demand of the stock depends mostly on how people think the company will perform in the future.

Stocks themselves are parts of “ownership” of a company. When company makes profit, they pay out to their owners, usually 0%-6% of the price of the stock annually, so they have a bit more to support their values than supply and demand.

Let’s say 3 friends decide to start a business. Adam contributes $50k, Bob contributes $25k, and Charlie also contributes $25k. The business then purchases equipment: computers, desks, machines, product etc. This $100k represents the business’s “Capital”. It then issues 100 “shares” of stock. Adam gets 50 shares, Bob and Charlie each get 25 apiece. They “Share” ownership of the company. You can say they bought each “share” of stock for $1k. This is the “Share Price” of the stock.

Over the next year, the business earns revenue of $200k. It pays its employees, Dan and Evan $100k, buys more equipment for $30k, and has other expenses like electricity and water for $10k. The leaves $60k in profit. This profit is taxed and the business is left with $40k.

This $40k is split between the owners according to the number of shares they own. Each share gets $400 ($40k/100) so Adam get’s $20k, Bob and Charlie get $10k each. This payment is called a “Dividend”, which as income to Adam, Bob, and Charlie is also taxed. Between the 3 of them, they only make $30k. The $60k in profit for the business turned into only $30k of profit for the owners. When you hear the phrase “double taxation of dividends” this is what is meant.

But we aren’t done. You see, the business bought $30k of equipment so the business now has $130k in capital. Each “share” isn’t worth $1k anymore; it’s worth $1,300 ($130k/100). The share price has gone up. This is called “Capital Gains”. Now, since Charlie owned 25 shares last year, and owns 25 shares this year, he hasn’t experienced any income so this Capital Gain is not taxed even though he has made a profit. The profit only exists “on paper” it is not “realized”.


Now Frank comes along and thinks “Hey, this stock made a 30% increase AND paid a 40% dividend. This is &^$#ing amazing! I wish I owned some of this stock.” Of course, Adam, Bob, and Charlie think this too so they aren’t willing to sell any shares for $1,300. Charlie is willing to sell 10 shares at $1,800 and Frank agrees. Charlie bought his 10 shares for $10k and sold it for $18k making $8k in profit (and only now does he pay “Capital Gains Taxes”).

Also, guess what just happened to the Share Price? In this way, the share price becomes divorced from the actual value of the business and more about people’s expectations about the business’s future value.

Now that, I hope, you see how there are 2 ways to make money on stocks, Dividends and Capital Gains, you can see how tax policy encourages different business behaviors. Tax dividends to shift towards capital purchases and share price increase, or tax Capital Gains to shift towards paying out profits. Each has their pros and cons.

Let’s say a company makes $100 million a year in profit, and pays all its profits as dividends. There are 50 million shares of the company in existence.

So for every share you own, you get $2 every year. Own 100 shares, you get $200 per year.

The price of the stock is how much you pay for that income stream. If the stock’s trading at $20 per share, it means you pay $20 now to get $2 per year. This is expressed in the P/E ratio (Price / Earnings), which in this case is $20 / $2, which is 10. P/E is like the “price tag”, how much you pay for $1 of annual profit.

So if you buy 100 shares for $20 each, you paid a one-time cost of $2000 to get a steady income of $200 per year.

The dividend isn’t guaranteed to stay the same. The company can increase or decrease its dividend, usually in response to increased or decreased profits.

Also the company can choose to invest some of its profits in improving itself, for example, instead of paying all $100 million to shareholders this year, it instead pays $80 million to shareholders and uses $20 million to create more / better products, or open / remodel stores, or save up a “warchest” of money immediately ready to respond to some problem or opportunity.

There are two basic strategies long-term investors use to make a profit:

– Dairy farmer / value investing: Buy a stock for $2000. Get a $200 check once per year. After 10 years, you have more than your original $2000, and you continue to own the stock which continues to give you $200 per year (or more if the company’s continued to improve).

– Meat farmer / growth investing: Buy a stock for $2000. Hope the company is successful, and you’ll eventually be able to sell the stock to someone else for $3000.