Making Money From Buying Stocks

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If you listened to the financial media or investing press, you might get the mistaken impression that making money from buying stocks is a matter of "picking" the right stocks, trading rapidly, being glued to a computer screen or television set, and spending your days obsessing about what the Dow Jones Industrial Average or S&P 500 did recently. Nothing could be further from the truth. 

In reality, the secret to making money from buying stocks and investing in bonds was summed up by the late father of value investing Benjamin Graham when he wrote, "The real money in investing will have to be made—as most of it has been in the past—not out of buying and selling, but out of owning and holding securities, receiving interest and dividends, and benefiting from their long-term increase in value." 

Buy and Hold Strategy

Investors today commonly refer to Graham's strategy as "buying and holding." To be more specific, as an investor in common stocks, you need to focus on total return and make a decision to invest for the long-term. This means that at an absolute minimum, expect to hold each new position for five years provided you've selected well-run companies with strong finances and a history of shareholder-friendly management practices.

As an example, you can view four popular stocks below to see how their prices increased over five years.

High-profile investors like Warren Buffett and Charlie Munger have held onto stocks and businesses for 25+, even 50+ years to make the bulk of their money. Other everyday investors have followed in their footsteps, taking small amounts of money and investing it for the long term to amass tremendous wealth. Here are two noteworthy examples:

Still, many new investors don't understand the actual mechanics behind making money from stocks, where the wealth actually comes from, or how the entire process works. The following will walk you through a simplified version of how the whole picture fits together.

Ownership in a Real Operating Business

When you buy a share of stock, you are buying a piece of a company. Imagine that Harrison Fudge Company, a fictional business, has sales of $10,000,000 and net income of $1,000,000. To raise money for expansion, the company’s founders approached an investment bank and had them sell stock to the public in an Initial Public Offering or IPO.

The investment bankers might have said, “Well, we don’t think your company's growth rate is overly ambitious, so we are going to price this stock so that future investors will earn a solid 9 percent on their investment plus whatever growth you generate … that works out to a value of about $11,000,000 or so for the whole company ($11 million divided by $1 million net income = 9 percent return on initial investment).”

Alternatively, the underwriters could have said, “You know, we want the stock to sell for $25 per share because that seems affordable, so we are going to create 440,000 shares of stock (440,000 shares x $25 = $11,000,000)."

That means that each share of stock in Harrison Fudge is allocated $2.72 of the company's profit ($1,000,000 profit ÷ 440,000 shares outstanding = $2.72 per share). This figure is known as Basic Earnings Per Share (EPS). In other words, when you buy a share of Harrison Fudge Company, you are buying the right to your share of the company's profits.

Consequently, if you acquired 100 shares for $2,500, you would be buying $272 in annual profit plus whatever future growth (or losses) the company generated. If you thought that a new management team could cause fudge sales to explode so that your share of profits would be 5x higher in a few years, then this would be an extremely attractive investment.

Determining How Much You Make

What muddies up the situation is that you don’t actually see your $2.72 per-share profits that belong to you. Instead, management and the Board of Directors have a few options available to them, which will determine the success of your holdings to a large degree:

  1. The company can send you a cash dividend for some portion or the entirety of your profit. This is one way to “return capital to shareholders.” You could either use this cash to buy more shares or spend it any way you see fit.
  2. The firm can repurchase its shares on the open market and keep them in-house. 
  3. It can reinvest the funds generated from selling stock into future growth by building more factories and stores, hiring more employees, increasing advertising, or any number of additional capital expenditures that are expected to increase profits. Sometimes, this may include seeking out acquisitions and mergers.
  4. The company can strengthen its balance sheet by reducing debt or by building up liquid assets.

Which strategy is best for you as an owner depends entirely on the rate of return management can earn by reinvesting your money. If you have a phenomenal business—think Microsoft or Wal-Mart in the early days when they were both a tiny fraction of their current size—paying out any cash dividend is likely to be a mistake because those funds could be reinvested into the company and contribute to a higher growth rate.

During the first decade after Wal-Mart went public, there were times in which it earned more than a 60 percent return on shareholder equity. Those kinds of returns typically only exist in fairy tales yet, under the direction of Sam Walton, the Bentonville-based retailer was able to pull it off and make a lot of associates, truck drivers, and outside shareholders rich in the process.

Berkshire Hathaway pays out no cash dividends while U.S. Bancorp has resolved to return more than 80 percent of capital to shareholders in the form of dividends and stock buybacks each year. Despite these differences, they both have the potential to be very attractive holdings at the right price (and particularly if you pay attention to asset placement) provided they trade at the right price; e.g., a reasonable dividend-adjusted PEG ratio.

How Stocks Make Money 

When you understand more about how stocks work, it’s easier to understand that your wealth is built primarily from:

  1. An increase in share price: Over the long-term, this is the result of the market valuing the increased profits as a result of expansion in the business or share repurchases, which make each share represent greater ownership in the business. In other words, if a business with a $10 stock price grew 20 percent for 10 years through a combination of expansion and share repurchases, it should be nearly $620 per share within a decade as a result of these forces assuming Wall Street maintains the same price-to-earnings ratio.
  2. Dividends: When earnings are paid out to you in the form of dividends, you actually receive cash via a check in the mail, a direct deposit into your brokerage account, checking account, or savings account, or in the form of additional shares reinvested on your behalf.

Alternatively, you can donate, spend, or save up these dividends in cash.

Occasionally, during market bubbles, you may have the opportunity to make a profit by selling your stock to someone else for more than the company is worth. In the long run, however, the investor’s returns are inextricably bound to the underlying profits generated by the operations of the businesses which he or she owns.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.