Last Updated on 3 November, 2022 by Samuelsson
Have you heard people talk about investing in stocks, how it is better than saving money, and how it makes sense to start investing at a young age? You’re probably wondering how stocks make money!
Stocks do not make money on their own, rather, since stocks represent ownership in the companies that issue them, their values are tied to those companies and how much money those companies are making. However, stocks are traded on the exchanges independent of the companies, so their prices can fluctuate widely.
Of course, there are so many things you need to know about stocks and how you can make money from them. Keep reading to learn more about them.
What Are Stocks?
Stocks, also known as equities, are securities that represent a part of ownership in the companies that issue them. Although stock and share are sometimes used interchangeably — especially in America — a share is a unit of ownership in a company, while a stock is a collection of shares of a company.
A company can issue its shares to the public and have them trade on the stock exchanges, independent of the company. However, the daily operational activities of the company — how much profit it’s making and how well it’s run — reflects on the price of those shares. An aggregation of the company’s shares that trade on the exchange constitutes the stock of the company. Investors who believe in the company’s prospects will buy its stock.
So when you buy the stock of a company, you are, as a matter of fact, buying a stake in the ownership of the company. And depending on the type of stock you buy, you may get the right to vote at the general meetings of the company and influence the decisions that affect how the company is run. The number of shares you own will determine how much influence you can have.
In addition to the voting right, when you own a stock of any company, you are entitled to a proportion of the company’s assets and earnings. So if the company usually pays dividends to its shareholders, you too will be paid according to the number of shares you own, whenever dividends are paid.
And, in event that the company liquidates, you are entitled to get a portion of the proceeds from the company’s assets. But this will come from whatever is left after the company’s debts and other obligations are settled. In other words, stockholders are the last in line when it comes to the proceeds of liquidation.
Companies typically issue two types of stocks:
- Common stock
- Preferred stock
Also called equity shares or ordinary shares, common stock normally gives the stockholder the right to vote at shareholders’ meetings. But when it comes to the company’s earnings, common stockholders cannot be paid dividends until preferred stock dividends are fully paid. The same also applies in events of liquidation: common stockholders are the last to get the proceeds from the company’s assets.
Preferred stocks often have the features of both an equity and a debt because they have priority over common stock when dividends are being paid. In the same way, during liquidation, preferred stocks have higher claims on the proceeds of liquidation than common stocks. However, preferred stocks don’t come with voting rights. There are many types of preferred stock, such as:
- Convertible preferred stock which offers the holder the option to convert into common stocks on a pre-agreed date
- Cumulative preferred stock whose dividends will accumulate for future payment
- Putable preferred stock which comes with a put privilege — the holder can sell them back to the issuer.
How Do stocks Work?
Stocks are designed for businesses to raise money to fund their operations. Basically, there are two ways a company can raise funds to finance its projects: borrow money (debt financing) or sell a portion of ownership in their companies (equity financing).
A startup company is more likely to choose the latter because of the problems associated with borrowing — the need for collateral and the burden of paying back the loan with interest.
After deciding to sell a portion of the company to get the required funds, the company will have to find people who will be interested in owning stakes in the company. But first, it has to decide the portion of the company it wants to sell and the number of units to divide the ownership stakes into.
In other words, the company will be divided into small units of ownership called shares. Each share represents a slice of ownership in the company. The company can be divided into any number of shares, but the larger the number of units, the less value each unit will have. Most times, the company will employ the services of an investment bank to help arrive at the most reasonable number of shares and the right price per share.
At this stage, the founding owners of the company must have decided the percentage of the shares they will keep for themselves and the ones to be sold. For example, assuming the company is divided into 1 million shares and the founding owners decide to keep 70% and sell 30%, then, 300,000 shares will be available for sale. It is important for the founding owners to keep a majority of the shares to themselves so that they can retain the control of the company.
Listing on an Exchange
With the help of the investment bank, the company will list the stock on the stock exchange and issue the 300,000 shares in our example to the public. This process is known as an initial public offering (IPO). Investors subscribe to the public offering and acquire the shares of the company. The number of shares an investor buys determines his stake in the company. For instance, if someone buys 100,000 shares, he has a 10% stake in the company.
Being listed on the stock exchange changes the status of the company from a private firm to a publicly-traded company, whose stock can be bought and sold on the stock exchange without any direct input from the company. Investors can then trade the company’s shares as they please: those who have shares in the company can sell their stock to raise money for personal needs, while other investors who want the company’s stock can buy from previous owners.
With the constant buying and selling, the price of the stock keeps fluctuating, as investors have different opinions about the real value of the stock. However, as the company grows and earns more money, the stock intrinsically increases in value and its share price will eventually rise to reflect that.
The Main Functions of Stocks
Since the idea of issuing stocks came into being in the 17th century in Amsterdam, stocks have always played important roles in the business world. Stocks are very beneficial to the issuing companies, the investors, and the society at large. Here are some of the functions of stocks:
To the company
Generally, most companies issue their stock to the public because of the numerous benefits involved:
Raising fund: By issuing its stock, a company can raise funds to finance projects and expand its business without much issues — no worries about paying interest.
Distributing risk: Stock issuance helps the founding owners of the company to distribute the risks associated with the business to a large pool of investors. In case the company fails, they don’t lose everything.
Gaining more visibility: Companies whose stocks are publicly traded tend to have more visibility as analysts and investors analyze and talk about them.
Payment option: Companies can use their shares as a form of currency in business deals, such as acquisitions, where shares can be used as a payment option.
Employee stock option plans: Publicly traded shares can be used to set up employee stock options plans which can help to attract more talented employees.
To the Investors
Investors buy stocks for different reasons. But for the most part, investors use stocks for the following:
Have a stake in a company: Buying the stock of a company offers an investor a portion of ownership in the company.
Earn income: Stocks act as a store of value, so a stockholder can sell some of his shares to raise money for his personal needs. Moreover, some companies regularly pay dividends to their stockholders, which can be a source of income.
Grow wealth: As the underlying companies grow and make more profit, their stocks increase in value, driving the prices of those stocks up.
Trading: Stocks are marketable instruments with speculative properties. A lot of people trade stocks for speculative purposes. These traders are active in the market, buying or selling stocks. In fact, stock trading is a popular profession.
Stock investing helps to grow the economy of a society. It provides people with opportunities to put their savings to good use. As people make their savings available by investing in stocks, companies use the money to grow their businesses and employ more people, thereby boosting the economy of the country
Here are other ways that stocks help the economy!
How Investors Make Money From Stocks
Investors buy stocks to make money, and there are basically two ways an investor can make money from stocks:
- Capital appreciation
- Dividend payments
A stock is said to have appreciated in value when its share price goes up. Capital appreciation is also called capital gain. It is the rise in the market price of the stock. In other words, the current price of the stock is higher than the amount an investor paid for it when he bought.
For instance, an investor buys a stock at $50 per share, and after one year, the stock is trading at $60 per share. The stock has made a $10 capital appreciation as the price went from $50 (purchase price) to the present value of $60. Selling the stock at this time will give a return of 20% from capital appreciation.
If, on the other hand, the stock fell from the $50 purchase price to $40, it would make a $10 capital loss, which is a 20% loss.
A dividend is a regular payment a company makes to its stockholders annually, semi-annually, quarterly, or monthly. It is a way the company rewards its stockholders for their loyalty. Usually, the money distributed to the stockholders is a portion of the earnings the company made during the period, and the rest of the earnings are retained to finance the company’s day-to-day operations.
Some companies that have a track record of paying dividends can even borrow to pay, to maintain their record. The amount of dividend and how it will be paid is decided by the company’s board of directors but must be ratified by the stockholders through a vote. Dividend can take several forms: cash payment or shares of the company.
Most times, a dividend is expressed as a percentage of the share price to give what is known as dividend yield. For example, if a stock is trading at $20 per share, and the company pays an annual dividend of $2, the dividend yield is 10%. A combination of the returns from dividend and capital appreciation is known as total return.
Examples of Dividend-Paying Stocks
Here are some of the companies that have consistently paid dividends and how they have performed over the years:
Procter & Gamble (NYSE: PG)
Almost everyone all over the globe knows Procter & Gamble, the maker of Pampers diapers, Crest toothpaste, and other household products. Procter & Gamble has paid dividends to its stockholders since 1891 and has been increasing its payout for the past 50 years and counting. During that period, its share price has soared — from $1.30 in 1969 to $118.90 in 2019.
Coca-Cola (NYSE: KO)
Everyone knows the simple but unique soft drink, Coca-Cola. This company has paid dividends since 1893. It has consistently increased its annual dividend for more than 50 years. Its current dividend yield stands at 3.5%, and its share price has been doing well over the years.
Being a financial asset, stocks don’t make money themselves. Their values are tied to the growth and profitability of the issuing companies. You can buy them to grow your wealth via capital appreciation and dividend income.
If you enjoyed this article you might also like our other articles answering common questions traders have!