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Wednesday, April 11, 2012

Basics Part 2

Some people wonder about how you make money on stocks. There are basically two ways.

The first is rise in share value. Let's pretend that you bought 100 shares of a Wizzy Cola Inc. for $10 per share in 2011. You hold onto Wizzy stock for a long time because it is doing well. Let's say that you haven't bought any new shares in Wizzy over the next five years, but the value of Wizzy Cola is now $15 per share. You originally spent $1000.00 (100 shares at $10 per share), but now your shares are worth $1500 (a $500 dollar profit.) If you hold onto Wizzy, then you have an unrealized gain of $500. It is unrealized because you haven't actually sold the stock and received the $500 in profit. Once you sell the stock, it becomes a realized gain. This is when the tax man comes knocking.

The second way to earn money on a stock is through a dividend. Some companies (usually older, or more established companies) pass out a certain amount of money per share to shareholders (usually quarterly, or every three months). This can be based on profits, but is usually fairly constant.

For example, Wizzy Cola Inc., declares a dividend in March of 5 cents per share. If you own 100 shares of Wizzy, you receive $5. Then in June, Wizzy declares a dividend of 5 cents per share. Again, you receive $5 dollars. In September, Wizzy (after a great summer) declares a dividend of 7 cents per share. Now, you receive $7.00. At the end of the year, Wizzy declares a dividend 5 cents per share. You receive $5 dollars.

During the year, you have received $22 dollars in dividends on your 100 shares. You can elect to receive this as a payment, or more wisely, use it to buy more shares. This is one way to build up your share balance.

For example, you own 100 shares of Wizzy, which you bought at $10 per share in January. In March, Wizzy shares are still worth $10 per share, so with your dividend, you buy 1/2 of a share ($5 worth). In June, Wizzy shares are worth $15, so you buy 1/3 of a share with your dividend. In September, Wizzy is worth $14 per share, so you buy 1/2 share with your dividend (of $7), and in December, Wizzy is $15 again, so you buy 1/3 of a share with your dividend.

Throughout the year you have purchased (1/2 +1/3+1/2+1/3) or 1.667 (one and two-thirds) new shares with your dividends. You now own 101.667 shares of Wizzy. Wizzy is now worth $15 per share. The total value of the Wizzy shares you own is now $1525.01, up from $1000 when you purchased it in the beginning of the year. If you sell your stock at $15 per share, then you would end up with $1525.01, raking in a $525.01 profit.

More in the next segment. Please comment or email me.

1 comment:

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