Investment 101: How People Make Money Through Share Market

Basically, people make money through share market investment through two ways - direct earning and indirect  earning.  Direct earning is through the dividend payout , whereas the indirect earning is through the appreciation of the share itself.

Example
If Tom buys 10,000 units of common share of ABC company at $1 each in January 2015, and after one year the company has announced a better profit, the price shoot up to $2 per share, then now Tom has total worth of $20,000 of shares. Compared to the money Tom spent to purchase the share ($10,000), he is said to have made a $10,000 profit out of his investment.

Under the same scenario, the ABC company has total announced dividend payout of $0.20 per share in the financial year 2015,  Tom would have received a payout of $2,000 in that year. By adding up, Tom has made total $12,000 in year 2015. If Tom sold the share in Jan 2016 at $2 per share, it is said that Tom has realized the profit of 120% for the year. If Tom has not sold the share, it is said that Tom has made a paper gain of 100% and a dividend yield of 20%.

Indirect Earning
Why is the capital appreciation is said to be indirect earning? This is because the price of the share is unregulated and close ended in nature. This means that the prices works on free market mechanism. Market supply and demand of the share itself will drive the movement of the share.

Closed ended asset means that the number of share available in the market will be of a fixed amount. For example, if ABC company has issued 1 million units of share during it's IPO (Initial Public Offering) , the will be only 1 million shares of ABC company available in the market at any point of time, until the company make a subsequent public offering or any issues of shares.

Imagine ABC company has just announced that their earning has increased by 30% compared to the same period last year. The investors noticed that the company is making good money. Assuming all other economical factor pertaining to the industry remains the same, there will be more people interested in becoming the owner of the company to participate with the growth of the company. The existing owner of the shares would not want to sell them at old price, and some of them would like to keep them for long term, at the same time the interested investor will increase, with people willing pay a higher price than before to buy the share. Therefore, there will be less seller and the selling price offered in the market will increase. Even though the company's net worth has increased, the investor actually make the money through the difference in the total price he bought and sold the share, which could be different from the gain in company value appreciation. In this case, the investor make money from other investor and not from the company's account itself.

The market participant are humans. Being human, we have emotions and sentiments. We have greed and fear. These are two main factors driving the prices of shares. The earning of capital appreciation is said to be indirect is because some times, for many factors,the movement of the share price is not reflected immediately after the company make money. Market is not rational most of the time.

Efficient market theory suggested that market is efficient, and the price of a particular share is at its fair value at any point of time. Well, if we all take in the fact that human sentiment is a factor, then yes it is true that at any point of time, the price of the share is effectively determined by (intrinsic value of share + market sentiment effect).  (how people make money through this will be explained in separate article, this article is meant to be basic for newbie ;-) )

Direct Earning
Dividend is considered a direct earning because there is no supply demand mechanism involved in the process of determining the amount the investor earn. Whether the company share has good demand or not, the amount of dividend received by the share holder is as per the amount announced by the company. It is a fixed earning, directly paid out by the company to the share holder and not by buying and selling of the ownership. Please note that the dividend announced per share is fixed, the dividend yield is a totally different thing depends on the price the investor bought the share.

Taking the above example, Tom is said to have make 20% dividend yield. However, if Tom bought the shares at the price of $2 per share instead of $1, the dividend yield would be recalculated as follows:

Dividend Payout ÷ Cost of Shares x 100% :
= $0.20 ÷ $2 x 100%
= 10%

Therefore, the higher the price you paid for the shares, the lower your yield will be. However, you are still being paid $2,000 as long as you own 10,000 units of shares, regardless of the price you paid for the share.

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