Many people see trading stocks and shares as a money pit, but it doesn’t have to be. Fortunes are made on the stock market all of the time, and though a lot of money is also lost there, that doesn’t mean that ordinary people cannot profit from it.
But how exactly does this work? The stock market is complicated, but many people lack even a basic understanding of how profits are actually generated. If you’re among them, read on to find out more…
Understanding Stocks
Before you can understand how money is made, you have to understand exactly how the market works. Access to the stock market is granted via brokers, such as Sucden Financial, who provide opportunities to purchase shares.
When you choose to buy a share of stock, what you’re actually paying for is a piece of the company. Imagine that you buy into Chocolate Wonderland, a fictional business. Chocolate Wonderland has sales of $30,000,000 and a net income of $3,000,000. The underwriting firm they approach price them so that future investors earn 9 per cent, as an example. As a result, they value the company at $33,000,000. The underwriters decide to price shares at $75, so they cut the company into 440,000 ‘pieces’ or shares of stock. This means that each holder of a share of stock is entitled to roughly $6.82 of the profit. This figure is the EPS (earnings per share). Thus, if you were to buy 100 shares for $7,500, you would be buying $682 in annual profit, plus whatever future growth or losses the company generated.
Where Does This Profit Go?
Of course, far fewer people would be confused if each shareholder simply received their annual $6.82 in profit each year. Where the money actually ends up is largely down to the decisions taken by the stocks management and Board of Directors. This can be used in a number of ways:
Cash Dividends
Some companies will award cash dividends, sending their shareholders some or all of their profit.
Repurchase of Shares
Other enterprises may choose to repurchases shares on the open market and destroy them. This is a complicated concept to explain, and is best understood by reading this article.
Reinvestment
Other companies will choose to invest in themselves and their future growth, sinking funds into building works, the hire of staff or advertising, for example.
Reduction of Debt
Some businesses may prefer to strengthen their balance sheet by reducing their existing debt.
How Profit is Generated
As you can see, the profit a company generates can be utilized in many different ways, but how do investors themselves benefit from this? There are two ways:
Increases in Share Price
The first way in which traders can profit is through an increase in share price, because the business has expanded, increased its profits or share repurchases have increased the value of each individual share. If Chocolate Wonderland, for example, grew 50 per cent in 10 years, after a decade, each share would be worth $10.23. The buyer in our example, who purchased $7,500 worth, would thus see their holdings after this period increase to $11,250, without any real effort on their part. Were they to sell this, they would have made a real cash profit.
Dividends
Dividends are another way to make a real profit, as shareholders are awarded capital to spend as they choose.
Could stocks and shares generate a healthy income for you?
