How Stocks Grow Your Money

By | September 18, 2013

Just how does one earn with stocks? Let me count the ways.

1. Cash Dividends.

Companies are owned by the stockholders (see this article to get an understanding of what stocks really are) – so generally, these owners expect their share of the profits. At the same time, companies are also separate legal entities – so it needs money and capital to operate. Hence, companies usually pay out their accumulated earnings (called retained earnings) in excess of their capital. If it is in cash, then it is called cash dividends. At times, the company may give out other assets like properties, though cash is the most convenient method considering it can be easily divided and allocated to shares.

2. Changes in market prices.

If you buy a stock at $1 and sell it for $3, then you get a profit of $2. It seems too little, but let’s say you bought a million stocks, then the $2 becomes $2.0 million. The risk here is if the stock prices drop to $0.5. Then you lose $0.5. But if you already bought a million stocks, then you lose half a million. This is why stocks are risky. You may gain a lot, but you may also lose a lot.

Then you say that you don’t have the cash to buy the million stocks, and you want to minimize your risk. That’s where options come in. Options give you the “option” to buy or sell a stock at a set price. For example, for $0.1, you get an option to buy a stock for $1 and you can exercise this right for a year. Two months later, stock prices go up to $3. By using your option, you get the right to buy the stock for only $1. Right after buying the stock for $1, you sell it at $3. Then you get a profit of $2 less the $0.1 cost of the option. What if stock prices drop to $0.5? Then you let the option expire and you lose the $0.1 option price.

3. Stock Dividends.

If a company has no spare cash to give out, then they can declare stock dividends. Stock dividends, in the accounting sense, merely transfer some of the retained earnings to paid up capital. In the stockholders’ world, stock dividends increase the number of stocks the holder has.

For example, you have 10 stocks of a company. As of now, those stocks are valued at $3. Then the company declares a 10% stock dividend, and you get one additional stock. Because of the influx of new stocks, the price of your stocks drop to $2.9, though now you have 11 stocks – with a total value of $31.9.  There is another thing that a company does – stock splits that increase the number of your stocks. Usually stock prices do not move proportionately as the stock dividends and stock splits do, and that’s when you earn.

 

Stocks get more complicated by the day. There’s stock rights, conversion options, classes of stocks, etc. But these are the basics, and it is only when you are done with the basics that you should move forward to the complicated ones. But these three are enough to start. So go ahead, start reading the business pages to see how the companies are doing, what are their future prospects and which stocks you should go buy to grow your money.

2 thoughts on “How Stocks Grow Your Money

  1. David

    Compounding interest on stocks is the magic to making them work for you especially if your young and have decades on your hands to watch that take effect. also buying the same amount each month regardless of the movement averages out the ups and downs of stocks overtime too

    Reply
  2. Pingback: Carnival of Personal Finance #430: The Double Edition for Dummies

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