Stock Market

When you own stock, there are two potential sources of profit:

1. Appreciation in the price of the security (e.g., you buy shares of a company for $10 and the stock prices increases to $25; you've made a $15 profit).

2. Dividends received; this is when the company mails you a check for your portion of the profits paid out to shareholders. Over the last century, around 40 percent of returns have arisen from dividends. Stocks that pay large and increasing dividends over time can be an excellent choice for investors that require current income upon which to live.

TIP: Market capitalization is the value of all of a company's outstanding common stock. A corporation with 2 million shares outstanding and a current stock price of $50 per share would have a market capitalization of $100 million.

An example may help. The Avalon Candle Company, a fictional enterprise, is a manufacturer of premium candles and scented products. The company has a market capitalization of $250 million (10 million shares of stock outstanding, each trading for $25). Last year, the business had a net income of $15.6 million.

Each share of common stock is entitled to a proportional interest in the profit. If you divide the company's net income ($15,600,000) by the number of shares outstanding (10,000,000), you discover that of the profits.

Once a year, the shareholders of The Avalon Candle Company vote to elect a Board of Directors. Among other things, this Board is responsible for ensuring the business is run well so that shareholders make as much money as prudently possible. One of the most important decisions it must make is how to pay youthe owner of Avalon's sharesyour $1.56 profit.

Generally speaking, the Board has two choices: It can either reinvest the funds in the business to expand future earnings per share by building new factories, creating new products, acquiring other companies, repurchasing existing shares, and paying down debt, or it can send you a check in the mail. Profits that reinvested in the business are known as retained earnings. Profits that are paid out to shareholders in cash are known as dividends. For the sake of our illustration, assume Avalon's Board decides to reinvest $0.50 of the profits, and pay the remainder, or $1.06, out in the form of a dividend.

If you purchased 500 shares of the company's stock, you are going to receive a check in the mail (in the event you hold these shares through your broker, the funds will be deposited into your account) for $530 ($1.06 per-share dividend x 500 shares). Your portion of the retained earnings would equal $250 (500 shares x $0.50 retained earnings for the year). In theory, these retained earnings will cause the share price to increase over time.