How do you make money from stocks? This is a common question from investors. You must be a regular listener of the investing press or financial media. There could be a wrong impression of how to make money from stocks. It may seem like it’s just a matter of choosing the correct stocks and trading quickly. You may be sitting in front of TV obsessing with the Dow Jones Industrial Average or S&P500. Nothing can be farther from reality.
Benjamin Graham, summed up the secret to making money from stocks and bonds. He wrote, “The real money should be made from holding and owning securities. By getting dividends and interest on the securities, one can enjoy a long-run increase in value. As an investor of stocks, you should focus on overall return. Decide to invest for long-run. This means at full minimum, intending to hold every new position for five years. Through this, you’ve chosen well-run firms with sound finances and shareholder-friendly practices.
Even Charlie Munger and Warren Buffett made colossal money on stocks they held for over 25 years.
Still, many are unable to understand the real mechanics behind money making on stocks. Where the money comes from? Or how the whole process works? If you’ve spent some time on our site, you know we offer resources on many advanced topics. This includes financial ratios, financial statement assessment and so on. But, the current issue is very critical, so get comfortable in your reading seat. We’ll take you through a simple version of how every piece fits together.
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To Make Money from Stocks, Start by Buying Ownership in a Business
When you buy a stock, you’re purchasing a share of a firm. E.g., say, Harrison Fudge, a fictional firm, has a net income of $1,000,000 and sales of $10,000,000.
The company wants to raise money for expansion. For this, the founder approaches an investment bank. He made them sell stock to the public through an IPO. The bank may have said, “According to us, your growth rate is not high. So, we’ll price this so that future investors will get 9% ROI, plus the growth that you generate. This figure works out to be nearly $11,000,000 + value of the entire firm. Now let’s suppose that the founders sell out entirely rather than the public issue.
The underwriters may have claimed, “You know, we want the stock to sell at $25 per share. As this looks affordable, we’ll cut the firm into 440,000 parts, or shares of stock ($25 * 440,000 shares = $11,000,000). This means that every share of stock is qualified for $2.72 of the profit. $1,000,000 profit / 440,000 shares outstanding = $2.72 per share. This figure is called the Basic EPS. In simple terms, when you buy a share of Harrison Fudge, you’re buying the right to pro-rata profits.
If you buy 100 shares for $2,500, you’ll be buying $272 in yearly profit plus any future gain/loss. You may think that new management can result in sales to accelerate. As a result, your pro-rata gains would be five times greater in a few years. Then this will become a highly attractive investment.
The Money You Earn on Stocks Will Depend on How the BOD and Management Assign Your Capital
What confuses the situation is that you don’t see the $2.72 gain you make. Instead, the BOD and management have some options. This decides the success of your stock to a great extent:
- They can transfer the cash dividend for the whole or part of your gain. This is a way to return shareholders’ capital. You can either use this money to purchase more stock. Or you can spend it anywhere you like.
- The management can re-buy shares in the open market and finish them. You can become extremely rich through this in long-run. For an explanation on this, read Stock Buy Backs: The Golden Egg of Shareholder Value.
- It can plow back the funds for future growth. This can take place by building more stores, buildings, increasing marketing, and so on. At times, it may also mean mergers and acquisitions.
- This can make the balance sheet strong by decreasing debts and building liquid assets.
What is ideal for you as an owner? This depends on the ROI management earns by re-investing the money. If your business is in its early days, paying a cash dividend can be a mistake. This is because money can be reinvested at a higher rate. There were times during the initial decade after Wal-Mar became public that it made over 60% on shareholder capital. This is amazing. See the DuPont desegregation of ROE for a more straightforward understanding. Such types of returns usually don’t exist. Under the guidance of Sam Walton, Wal-Mart pulled it off. This made many truck-drivers, associates and external shareholders wealthy in the process.
Berkshire Hathaway doesn’t pay any cash dividends whereas U.S. Bancorp has decided to give dividends and stock buyback options. It plans to return over 80% of shareholders’ capital. Despite the dissimilarities, both companies can be very attracting holdings at the correct price. And especially if you’re careful about asset placement. The holdings must be trading at the correct price; e.g., an affordable dividend adjusted PE Ratio.
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Eventually, All Money You Earn on Stocks Comes Down to Elements of Total Return, Including Dividends and Capital Gains
Now that you know this, it’s simple to understand that your money is mainly built from:
- A rise in share price. In long-run, this is the outcome of market valuing the risen profits. The profits may increase due to share buybacks or business expansion. Every share buyback means higher ownership in the business. E.g., a business having a stock price of $10 increases by 20% for ten years. Such an increase may be through a mix of share buybacks and expansion. Then it must be around $620 per share in a decade due to such forces. Provided Wall Street maintains the same PE Ratio.
- When a company distributes earnings as dividends, you may get cash in many ways. This could be through check in the mail. Or additional shares reinvested through your account. And even a direct deposit in any of your account. Or, you can also spend, donate or accumulate such dividend in cash.
During market bubbles, you may make a profit by selling at a higher price. But, in the long-run, investors’ returns are linked to the underlying profits a business generates.
How Professional Day Traders Earn Money through Stocks?
Many people ask us – “How professional day traders earn in stock markets?”
There’s an aura surrounding Wall Street and the Stock market which involves huge money. Many people aren’t correctly familiar with the stock market. They only think that there are too much money inflow and outflow.
Few of us have even started disliking everything related to the stock market. This is because they’ve all the money which we should be having. If you can’t beat them, join them. Correct?
We continue to receive an increasing number of question on day trading. Hence, we plan to explain it a bit more.
Basics of Day Trading: How They Make Money in Stock Market?
Today’s financial system is more complicated than what it was 10-20 years ago. The basic logic behind the existence of stock markets is that firms need money for growth. Once a firm reaches a certain point, it needs more money for growth. A private firm turns into a public firm. And this is how it first appears on the stock market.
The stock market is like eBay. eBay is the modern-day version of a yard sale. We all have items we don’t need, but they still hold some value. And we want to make money out of them.
A stock market is the same concept. But with firms that need money to keep growing. Ultimately, a firm becomes so huge that they stop taking money from their family, friends, and banks. They go public to get the cash they need to continue expanding. Once a person invests in a firm through the stock market, he/she becomes co-owner of the firm.
Stock markets deal in shares of companies. If there are 100 shares of Microsoft and you buy 1, you hence own 1% of Microsoft.
This is relative because there’re billions of shares of some firms.
Every firm is placed in a category of stocks known as stock indexes. This again is similar to the groups on eBay. If you want to buy a laptop, you’ll search in the electronics segment. When you want to buy a new bed, you will search in the furniture segment. Groups on eBay differ a bit from stock indexes. But, from a layman’s eye, we can see at it through the same lens. The NASDAQ composite index, for instance, has mainly technology stocks. S&P500 Index contains 500 biggest public firms in the US.
Hence, once a firm goes public, we start investing in it. The remaining shares have value, and the public determines this value based on the stock market. For anything with value, you can estimate its future value. Therefore, the stock market exists. And this is how professional day traders make money on the stock market.
They sell and buy stocks on their future value.
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Technical vs. Fundamental Analysis
To identify the value of a stock, traders use two models. Technical analysis and fundamental analysis. It’s critical to note that these two methods are the primary forms of trading.
Fundamental analysis includes understanding things like the situation of a firm. This is done by looking at its management, future potential, competition, etc. The idea here is to identify if a firm is in an excellent state to grow or not. Will its value increase over time?
Once a firm grows in value, it satisfies its investors and traders.
When a trader was buying the company’s stock, it would’ve had a low price. Now due to the increased value of the stock, the trader makes money.
Technical analysis doesn’t include things stated above. It strictly entails reviewing a chart containing some indicators and identifying patterns. One random example could be if some company goes up during a specific time of the year.
Let’s suppose that Microsoft will have higher sales during the holidays. Now we may expect it’s a stock price to increase during the holiday season of the year. A trader looking at Microsoft may seek patterns in price changes during a specific time of year.
Technical analysis doesn’t include an analysis of a company’s management of financials. It merely includes observing charts and taking decisions.
Professional traders have merits and demerits with both forms of analysis. But, this also depends on the type of trader an individual is.
If you seek to invest in a firm for long-term, we recommend fundamental analysis. We strictly prefer technical analysis because of the fluctuating economic times of today. It’s not smart to have your money in the market when anything volatile may happen.
It’s also time-consuming to see news and match dots with different types of opinions. Instead, we turn on the laptop and start observing a chart. Do a pre-market analysis and begin trading.
Most traders see the market through technical analysis. They’re usually grouped into three types of traders: swing traders, scalpers, and intraday traders. All three types of traders aim to do the same thing – make money via the difference in value. The only difference between them is the time they spend on their positions.
Professional traders who make profits on the stock market with greater frequency but low margins are scalpers. The aim is to take benefit of small irregularities in the market. This is beside quick movements, i.e., rapid changes in value.
A scalper may be in a position for only 5-10 seconds — the maximum a minute. A scalper also places greater frequency of trades. This is because their margin is usually lower per trade. A higher frequency (exiting and entering trades) is needed to make more profits.
Professional traders who make money on the stock market daily are intraday traders. An intraday trader doesn’t hold a position overnight. Hence the name “intra-day.” These traders usually are in positions for a few minutes to a few hours. Intraday traders are not as high-frequency as scalpers. But, they trade more frequently than swing traders.
We consider us as intraday traders. This is because we trade between an hour or two per day with TheDayTradingAcademy.com. Many of our traders make profits within a couple of hours per day. Our live classes also span a few hours. This is because the best activity in markets is within the initial few hours.
Professional traders who make money swing trading are swing traders. These day traders need more extended period. A swing trader uses technical or fundamental analysis. But he/she remains in trade for a few days and even weeks. To compare with intraday or scalper, a swing trader can be in a position for weeks as well. But, an intraday trader is never in a position for even a night.
The “swing-trader” term indicates that someone plays the swings of the stock market, instead of quick movements.
There’re also much longer day traders known as position traders. These traders hold positions for many weeks and even months. We’re not discussing those traders in this post.
The entire basis of a trader making money through stock market is correctly estimating stock value. A company’s stock is the price at which the common man says it’s worth.
As the financial systems have transformed, it has turned more complex. There’re more investment tools than mere stocks to invest in. These could be options, futures, stocks and even FOREX. The basic idea of making money through stocks is simple. Estimating the value of a company and making money if the estimate is correct.
An important point to note is that a trader can make money when the market goes either up or down. If we estimate the value of the stock, we can also identify that the value is falling. And then we can make money even on that.
Professional traders can make more money when the market is bearish. That is, when there is a crisis or when the economy is going through a recession. One of the reasons we love day trading is because we do make more money during an economic crunch. We still hope for the best for you.
After reading this How Do You Make Money from Stocks? Different Approaches, what do you think? Which approach would you use while investing in stocks? Please feel free to share your comment with us. We are looking forward to hearing from you.
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