My latest video outlined how fixed income or bond investments work, and how specifically you make money investing in those. My topic for today is how you really make money buying stocks.

As I outlined in my video: Isn’t Investing Just gambling, a company can raise money to invest in internal projects or acquire other companies by issuing common shares that investors purchase. Once those shares have been distributed to the public, they can be bought and sold on the stock market every second of the trading day. You buy that share for price that a seller is willing to trade the share for. Once you own those shares as an investor, you can make money in three ways.

First off, let’s discuss how the price of a company is determined.

The price is essentially the discounted value of the company’s future profits, per share. Let’s take a very simplified example. Let’s assume that company XYZ will be around for the next 5 years. During that time I expect the profits of the company per share (or earnings per share in industry jargon), to be $5 each year. 5 years of $5 earnings per year would result in a share price of $25. Now we all know that $5 today is more valuable than $5 five years from now, so in reality, that would be discounted and the share price would be less than $25, let’s say $22. Another investor might only think that the company will produce $4 in earnings each year, so they value the share at $20. Yet another investor might agree with my $5 per year earnings, but discounts the $5 in 5 years at a different rate than I do, so he thinks the shares are worth $23, rather than my $22. The share price of a company can be calculated many ways, or it can be calculated the exact same way but with different assumptions. So how do you get to that share price you see on Google Finance? That’s the job of the stock market. The market is a big calculation machine and incorporates everyone’s view on the price of the share and comes up with the best guess of what the share price is. Let’s say that the “market” agrees with my price for the share of $22 and I go ahead and buy that stock.

So how do I make money on my XYZ shares?

The first way is through capital appreciation, or capital gains. This happens when the company does well. If they earn or are now expected to earn higher profits than $5 per share, then the share will be worth more and people will be willing to pay a larger price for those higher earnings. I bought the share at $22 but now it’s worth $25. I just made money and could sell that share for a $3 profit. With the higher earnings, the company can take that money and reinvest it in new projects, products, or services that will then increase their profits even higher, thus increasing the price of the shares.

If the company doesn’t have any really good opportunities to invest in new products and services, or they’ve already funded those and have excess profits, they could pay you dividends. This is the second way to make money investing in stocks. Say the company has earned that $5 in profits for the year, and $3 per share is used to fund a new project. The remaining $2 is extra that can be paid out to shareholders as a return on their money. Companies can also pay out dividends by giving you extra shares instead of cash, but this is not as common. But… don’t make the mistake assuming that dividend companies are way better than companies who don’t pay dividends, because you get the increased $25 share price AND the $2 dividend. It doesn’t work that way. If you’re paid out that $2 dividend, the company is has now gotten rid of $2 per share so the company isn’t as valuable. As such, the share price of the company falls by $2.

All things being equal, you should be indifferent as to whether a company pays a dividend or not. If you receive a dividend from a company, their share price will fall by the dividend amount. So rather than having a $25 share, you have a $23 share + $2 in your pocket that you have to decide what to do with (keep it as cash, reinvest it in the same company, or invest it in something else).

The final way to make money through owning stocks is through share repurchases. This is where the company decides to take its excess cash and rather than sprinkling that out to all the investors through dividends, they’ll buy some of the outstanding shares back. What this does is it reduces the number of shares out there. That means that your shares will own a higher proportion of the company. Rather than expecting the company to earn $5 per share, since there are fewer shares, but the company is worth the same amount, you might expect $7 per share now so the share price goes up.

In essence, you make money owning stocks when:

  1. The price of your shares increase in value above what you paid for them, called a capital gain or;
  2. By receiving a dividend payment from the company. For the tax-sheltered investor, whether you earn a return through dividends or the share price of the company rising, you should be indifferent. For a taxable investor, it will depend on your tax bracket, but I’ll get into that in a future video.