If you tune into financial media, you might pick up the wrong impression that winning in the stock market is simply a matter of “choosing” the right stocks, trading aggressively, keeping your eyes on the tv or computer screen and constantly obsessing about how S&P 500 and the Dow Jones Industrial Average are doing at the moment. This is nowhere near the truth.
In reality, the key to making money from purchasing stocks and bonds was perfectly summed up the late Benjamin Graham,”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.” In other words, you should set your sites on the total return and invest for the long term. Basically you should expect to maintain each new position for about years at the absolute minimum.
That is the way real wealth is built in the stock market for outside, passive investors.
That is how:
- A farmer from a dairy farm outside Kansas City earned millions of dollars without the knowledge of his children.
- Anne Scheiber, a retired IRS agent built a portfolio of $22 million (this was prior to her death in 1995. Today (accounting for inflation) this would amount to over 63 million dollars.
- Jack MacDonald, attorney, earned $188 million
- Grace Groner, retired secretary, acquired a stock portfolio of $7 million.
- Lewis David Zagor, a man who lived in a small apartment in NYC earned $18 million.
- Ronald Reed, a janitor, earned over $8 million.
These are just a few of the hundreds of “secret millionaires” who earned their fortunes in the stock market.
Did you know that even high-profile multi-millionaire investors like Charlie Munger and Warren Buffet made most of their money on bonuses and stocks they held for over 25 years, some even for 50 years?
Many investors don’t have a basic knowledge of the general theories behind earning money from stocks; how the profits originate or even have a clue as to how the entire process functions. If you are familiar with our site, you see that we have a wealth of resources on topics that are pretty damned including: financial ratios, capital gains tax strategies and financial statement analysis. This is an important topic to understand so get a cup of coffee, pull up a comfy chair and let me guide you through an abridged, simple version of how this all fits together.
Purchasing Ownership is Your First Step towards Making Money in Stocks
When you purchase a stock share, you are purchasing a “piece” of a business or in simple terms own a company. Take Harrison Fudge Company (a purely fictional company) with sales of $10 million and a net income of $1 million. In order to raise money to expand the business, the founders of the company have seeked out an investment bank to sell stock to the public on their behalf in an Initial Public Offering (IPo)> They could have said. “Sorry, we are don’t think your projected growth rate is accurate so we will price this so future investors will earn 9% on their initial investment plus whatever growth you earn…which works out to be around $11 million for the their economy. (11 million divided by 1 million net incomes is 9% return on the initial investment.). Let’s assume the founders decided to sell out the company as opposed to issued stock. (for an explanation refer to: Investing Lesson 1: Introduction to Wall Street)
Or the underwriters could’ve said, “We wish the stock to sell at $25 a share as this seems affordable so we are going to divide the company into 440,000 shares of stock (440,000 shares at $25 a share is 11 million dollars). That means that each share, or piece, of stock is entitled to $2.72 of the profit ($1 million profit +440,000 outstanding shares $2.72 per share). This is known as a Basic EPS (earnings per share). Basically, you are purchasing the right to pro rata profits when you purchase a share of Harrison Fudge Company. If you purchased 100 shares for $2,500 you would actually be purchasing future growth or losses the company earns, plus $272 in annual profit. This would be an extremely profitable investment if you believe that new management could cause sales to explode making your pro-rata profits 5x higher in just a few years.
The Money You Earn From Stocks Solely Depends Upon Capital Allocation by Board Of Directors and Management
What complicates the situation even more is that you won’t actually see the $2.72 profits that you have earned. Instead, the board of directors and management, with a few available options, will to a large degree determine the success of your holdings.
- It can build up liquid assets or reducing debt to strengthen the balance sheet.
- It can destroy shares by repurchasing them on the open market. (For an understanding on how this can in fact make you extremely wealthy, read: “Stock Buybacks: The Golden Egg of Shareholder Value.”
- You could receive a cash dividend for either the entire, or a share of, your profit. This is a method of “returning capital to shareholders.” You could either spend this money or use it to purchase more stock shares.
- They could reinvest the funds to build more factories, stores, more staff, better marketing or any additional expenditures for future growth that are expected to raise their profits. This may even include acquisitions and mergers.
Which of these is the best option for you as a stock owner? This would depend on the rate of return the management is able to earn if they chose to reinvest your money. For a highly successful business such as Wal Mart or Microsoft in their early days when they were just a mere fraction of their current size would pay out a cash dividend would be an error as those funds could instead be reinvested for a higher rate. When Wal Mart went public there were times Wal Mart earned more than 60% profits. That’s truly unbelievable. (see the Dupont desegregation of ROE as a easy way to understand this). Those kinds of returns don’t usually exist, however, thanks to Sam Walton, the Bentonville based company was able to make a lot of truck drives, employees and shareholders very wealthy in the process.
US Bancorp has promised to return to its shareholders more than 80% of capital a year as dividends and stock buybacks while Berkshire Hathaway does not pay out any cash dividends. However, despite these differences, both companies have the potential for high earnings at the right price (especially if you follow asset placement) provided they do trade at a reasonable PEG ratio in other words at good price. I personally own stock in both of these companies at this time and would be irate if USB chose to follow this same allocation process as Berkshire as they do not have the same opportunities for it to result as the probation in place of bank holding companies.
Ultimately, Any Money You Make from Your Stocks Comes Down to a Hand of Components of Total Return, Including Dividends and Capital Gains
Now that you have some basic knowledge, you will be able to understand that your wealth is built from:
- An increase in share price. Long-term, this is the end means of the market valuing the increased profits as a result of business expansions or repurchases of shares, which ensure that each share represents greatest business ownership. Basically, if a business with at 420 stock price increases 20% over 10 years via share repurchase and expansion, the value should be about $620 per share within that time; assuming Wall Street holds the same price-to-earnings ratio.
- Dividends: You will actually receive a check in the mail, or a direct deposit in your checking account, savings account or brokerage account. Or you could receive this amount in the form of additional shares which are reinvested on your behalf. You can donate, pile these dividends in cash or spend your earnings.
On occasion, during a market bubble, you could have the opportunity to increase your profits by selling your stock to someone for more than the company is worth. However, in the long term, the returns of the investor are typically underlying profits generated by the business to which they own.
If you are interested in learning more about this, check out: “The 3 Ways You Actually Make money investing In Stocks”, Also you might be interested in checking out my guide to “Investing in Stocks.”