Part 2: How do I Make Money Investing
Back in part 1 we introduced the idea of owning a share of a company, and that investing in equities was going to be a major part of investing. So how does owning a company help your investments to grow?
If you are a part owner of a company, and if the company makes a profit, a part of that profit essentially belongs to you. However, it’s not like you can walk up to your local Walmart, flash a share certificate, and reach over the counter to take a few bills out of the register.
There’s a big difference between being entitled to something and automatically getting your hands on it. When you own shares in a company there are a few steps between how much money the company makes and how much you as an investor make. There are also a few different ways that investors can make money from their investments, though they mostly come down to dividends and capital gains.
The first way that investors can make money is if the company they own sends them some cash directly. This is called a dividend.
A company can choose to pay out part of their profits to the shareholders. When the dividend is declared, it’s defined as a certain amount of money per share, to be paid to shareholders of record on a certain date. So if a company decides to pay out $0.15/share and you own 100 shares, you’ll get $15 in cash appearing in your brokerage account, almost like magic.
There are some steps between the company making a profit and paying the dividend, and it is not automatic. That means that there can sometimes be big disconnects between what a company earns in a given year, and the dividend they pay out,
Generally, companies don’t pay out all of their earnings to their shareholders as dividends. It can make sense in many cases to hold on to some of those profits to re-invest within the company so it can grow. Indeed, many companies don’t pay any dividends and may not have plans to in the future, choosing instead to retain any profits inside the company – often to re-invest for continued growth, or perhaps to pay down debt.
Sometimes companies will choose to pay out more than what they made in a given year in dividends. For example, when investors are used to receiving a certain amount each year, the company may feel pressure to maintain the dividend even if they had a loss for the year.
These real-world complications can mean that for particular companies at particular points in time it can be hard to see how the investor gets a portion of the company’s profits, but in general over very long periods of time, we can expect that as companies make money, their investors should make money too.
The other main way that investors make money from their investments is through capital gains – their shares increasing in value.
If a company has 10,000 shares in total, and made $1,500 in the last year, they could pay out a $0.15 per share dividend, and your 100 shares would produce $15 in cash in your brokerage account. However, if they didn’t pay that dividend out and instead kept the cash, your investment should – in this highly simplified example – still be worth $15 more. So instead of getting the cash as a dividend, instead the value should appear as a capital gain: an increase in the value of your shares.
In practice, there are many things that will influence how much a company’s shares are worth, but as the value increases, you as the investor have a capital gain – and conversely, a capital loss if the shares go down in value.
In theory and in general, as companies do well and make money over the long term, their investors should make money over the long term as well, through some combination of dividends and increases in their share prices. But this can be a loose relationship, especially in the short term. Predicting exactly how a company’s stock price will react to the performance of the company itself can be extremely hard.
A very common question is how compound growth works when investing in stocks because they don’t pay interest. But the math works the same as long as the investment grows: if a share of XYZ is worth $100 today and grows 5% over a year to be worth $105, and grows 5% again over the following year, the same compound growth math applies and after two years the investment would be worth $110.25.
Similarly, if the growth came from dividends, as long as the investor uses those dividends to invest in more shares then it’s compounding growth. That re-investment doesn’t have to be back into the same company, either – it’s still compound growth if you buy another investment that grows over time (or pays dividends or interest).
For example, let’s say a share in XYZ pays a 5% dividend: $0.25 in dividends per share each year on a $5 stock, and also assume for simplicity that the price of a share doesn’t change. An investor with $100 would buy 20 shares of XYZ, then get $0.25 * 20 = $5 in dividends, enough to buy one more share. The next year they would get dividends on their 21 shares for $5.25 in dividends, bringing their total value after two years to 21 x $5 = $105 in share value + $5.25 in the most recent dividend, for a total of $110.25 – the same as the compound growth math said we would have after 2 years of a 5%/year return.
In practice, the amounts will be different every year but the growth compounds nonetheless. A way to measure the average growth per year after many years of different growth rates is the Compound Annual Growth Rate (CAGR) – there are many CAGR calculators on the internet to help you calculate what average growth rate might result from different starting and ending values.
The historical long-term return of investments is typically given as a CAGR. For example, if we say that “the stock market has historically returned 9% per year” we do not mean that every single year the return was 9% exactly. There were ups and downs – and more on that in a future installment – that produced a final return that was the same as if you had compounded at a steady 9% over all those years.