How do people make money in the stock market?
Ways of making money from the stock market
Most people invest in the stock market to make money so that they can achieve their financial goals. The two ways of making money from stock markets include capital gains and dividends.
- Capital gains
The first and most important way of making money from the stock market is capital gain. A capital gain is the profit made by an investor when they first buy equity shares of a company or equity mutual fund units at a lower price and later sell them at a higher price. The capital gain per share or mutual fund unit is the difference between the selling price and the buying price. The total capital gain is the capital gain per share or equity mutual fund unit multiplied by the number of shares or mutual fund units.
For example, as part of his asset allocation, Karan bought 100 shares of Reliance Industries for Rs. 1,700 per share. After 14 months, he sold the shares for Rs. 2,200 per share. In this transaction, Karan made a capital gain of Rs. 500 per share and a total capital gain of Rs. 50,000 on 100 shares.
Depending on how long the equity shares or equity mutual fund units are held before selling them, the capital gain can be short-term capital gain or long-term capital gain. When the equity shares or equity mutual fund units are sold for a lower price than what they were bought for, it is known as a capital loss.
- Short-term capital gain: When the equity shares or equity mutual fund units are held for less than twelve months, then the profit made on the sale of such shares or equity mutual fund units is known as short-term capital gain (STCG). There is short-term capital gains (STCG) tax applicable on STCG. The STCG tax is applicable at the rate of 15% + cess on the STCG amount.
- Long-term capital gain: When the equity shares or equity mutual fund units are held for more than 12 months, then the profit made on the sale of such shares or equity mutual fund units is known as long-term capital gain (LTCG). There is long-term capital gains (LTCG) tax applicable on LTCG. In a financial year, the LTCG tax for equity shares or equity mutual fund units is exempt for the first Rs. 1 lakh and 10% on the incremental amount, without indexation benefits.
Shareholder wealth created by Infosys
To understand the wealth that can be created for long-term financial goals with equity investment let us take the example of Infosys. If someone invested in 100 shares of Infosys at the time of its IPO in 1993, the total investment would have been worth Rs. 9,500 (issue price of Rs. 95 per share).
(Source: Page 148 of Infosys Annual Report 2019-20)
As of March 2021, after all the bonus issues and stock split, the investor would have 1,02,400 shares. The total value of these shares is Rs. 13,70,11,200 (Rs. 13.70 crores) based on the share price of Rs. 1,338 as of 29th March 2021. So, in 28 years, an investment of Rs. 9,500 has created a wealth of Rs. 13.70 crores, thus growing the investment by a mind-boggling 14,422 times. This is the kind of potential wealth that you can create with long-term investments if you start investing early.
The second way of making money in the stock market is dividends when you hold equity shares. The profit earned by companies is transferred to their reserves. These reserves are then primarily used for two purposes which include meeting the financial requirements of the business and for declaring dividends. A dividend is a part of the company’s profit that is paid out to shareholders. As an investor in equity shares, there are certain features that you need to know about dividend income:
- Dividend per share: The dividend is declared on a per-share basis.
- Dividend declaration: The dividend is declared by the Board of Directors and has to be approved by the shareholders. For example, on 11th February 2021, ITC declared an interim dividend of Rs. 5 per share.
- Ex-dividend date: On this date, the share price gets adjusted (reduced) by the dividend per-share amount. The share trades ex-dividend on this date. The ITC Board of Directors fixed 22nd February 2021 as the ex-dividend date. On this date, the price of ITC shares got adjusted (reduced) by Rs. 5 and started trading ex-dividend.
- Record date: As a shareholder, for you to be entitled to receive the dividend, your name should appear in the company shareholder records at the end of the record date. In the case of ITC, 23rd February 2021 was fixed as the record date for determining the entitlement of shareholders for the dividend. So, if your name appears in the ITC shareholder records on 23rd February 2021, then you are entitled to receive the interim dividend of Rs. 5 per share declared on 11th February 2021.
- Dividend payment date: This is the date on which the actual dividend amount is credited to the shareholder’s bank account. The ITC shareholders received the dividend of Rs. 5 per share on 10th March 2021 in their bank account.
Declaring a dividend is not obligatory for a company. In a particular year, if the company’s profitability has not done well or the company has made a big acquisition or invested in a big project, then it may declare a lower dividend per share or altogether skip dividend payment for that year.
Dividend distribution policy and pay-out ratio: The amount of dividend declared depends on the stated dividend distribution policy of the company. Usually, companies that are in growth mode or have high debt levels declare either no dividend or the dividend per share is lower. Companies that are debt-free and have high free cash flows declare a higher dividend per share.
For example in March 2020, ITC announced a new dividend distribution policy superseding the earlier policy adopted in January 2017. The company announced that in the effective financial year 2019-20, the dividend pay-out ratio is expected to be around 80% to 85% of the profit after tax. This means from 2019-20, ITC will distribute 80 – 85% of its annual profits as dividends to its shareholders.
A lot of companies declare dividends once a year, known as the final dividend. Some companies declare dividends two times a year, known as interim dividends and final dividends. Some companies like HCL Technologies pay quarterly dividends.
Example of dividend payment
Let us see how a company pays dividends every year, with the example of Infosys.
(Source: Infosys website)
We discussed in the earlier section if an investor bought 100 shares in the Infosys IPO, he/she would be holding 1,02,400 shares after all the bonus issues and stock split. In the year 2020, Infosys paid a total dividend of Rs. 17.50 per share. So, on the 1,02,400 shares, the investor would have earned an annual dividend of Rs. 17,92,000 (Rs. 17.92 lakhs) in the year 2020. If we add the cumulative from 1993 to 2021, that amount will be substantial and may also end up crossing Rs. 1 crore!
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