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How You Profit from Stocks
by WealthEffect Staff
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When you buy stock, you are buying a share of future profits
 
  Some of those profits are paid to you immediately as dividends  
  The remainder is reinvested in the company to grow profits  
 
1.

The profits of a company are determined by taking its sales and deducting its costs: materials, labor, interest on debt, taxes. These profits belong to the company's owners: its stockholders. When you purchase shares of stock in a company, you are effectively buying a piece of the profits.
 
 
2.

The profits can be paid out to shareholders immediately as dividends or retained by the company for future growth. Dividends are usually paid in cash each quarter — this dividend yield gives many investors great comfort since the cash payments are a steady, tangible return on their investment. On the negative side, dividends are immediately taxable at your highest tax bracket and, if you don't need to spend the dividend cheques, you have to find someplace to invest them.
 
 
3.

The profits which are retained by the company are reinvested to finance future growth (build a new factory, launch a new product, enter a new market, etc.). Accordingly, profits will be higher in future years. How much higher will depend on how attractive the reinvestment opportunities are: the more attractive the opportunities, the more profits should be reinvested and the faster future profits will grow.

The value of your stock will grow with the value of the company you own, and the value of the company will grow with its profits. The price of your stock, the quote in the paper on any given day, might be less than or greater than that value. But remember two things:

  • The price of the stock over time will rise with the value, generating a capital gain on your investment.
  • In the meantime, you have the luxury of buying more when the price is too low. You are never forced to buy, however, and you are never forced to sell.

That's not a bad deal.

To see the Return on Investment chart, click here.

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