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

Question

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

In: Economics

Answer 1

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”.

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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.