How do stocks work and how do you make a profit off of it??
In: Economics
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.
Latest Answers