Stocks can make money for investors in two main ways: capital gains and dividends. Understanding both is essential for anyone starting their investing journey. In this guide, we break down each method with simple examples.
The Two Ways Stocks Make Money
Capital Gains: You make money when you sell a stock for more than you paid for it.
Dividends: You receive cash payments from the company while you own the stock.
Some stocks offer both. Others focus on one or the other. Let us explore each in detail.
Capital Gains: Profit from Price Increases
Capital gains are the most talked-about way to make money from stocks. When you buy a stock at one price and sell it at a higher price, the difference is your capital gain.
Simple Example
You buy 10 shares of XYZ Company at $50 per share ($500 total).
A year later, the stock price rises to $75 per share.
You sell all 10 shares for $750.
Your capital gain: $750 - $500 = $250 profit (50% return).
Capital gains only happen when you sell. If you continue holding the stock, any increase in value is called an "unrealized gain" because you have not actually pocketed the profit yet.
What Drives Stock Prices Up?
Stocks go up in price when more people want to buy than sell. Several factors drive this demand:
- Company growth: When a company grows its revenue and profits, the stock becomes more valuable
- Positive earnings reports: Beating profit expectations often pushes prices higher
- Industry trends: If a sector becomes popular, stocks in that sector rise
- Economic conditions: A strong economy helps most companies
- Investor optimism: Positive sentiment drives buying
Over the long term, stock prices generally follow company performance. A company that consistently grows its earnings will likely see its stock price grow too.
Dividends: Regular Cash Payments
Dividends are cash payments companies make to shareholders from their profits. Not all companies pay dividends, but many established companies do.
Dividend Example
You own 100 shares of ABC Company.
ABC pays a quarterly dividend of $0.50 per share.
Every quarter, you receive: 100 shares x $0.50 = $50
Over a full year: $50 x 4 quarters = $200 in dividend income
Dividends provide income without selling your shares. Many investors love dividends because they provide cash flow you can use or reinvest.
Understanding Dividend Yield
Dividend yield tells you how much dividend income you get relative to the stock price. It is calculated as:
Dividend Yield = (Annual Dividend per Share / Stock Price) x 100
Dividend Yield Example
A stock pays $2 per share annually in dividends.
The stock price is $50.
Dividend Yield = ($2 / $50) x 100 = 4%
This means for every $100 invested, you receive $4 per year in dividends.
Typical dividend yields range from 1% to 5%. Some high-yield stocks pay more, but very high yields can be a warning sign of financial trouble.
Dividend Reinvestment
Many investors reinvest their dividends by automatically buying more shares. This is called a Dividend Reinvestment Plan (DRIP). Over time, reinvested dividends can significantly boost your returns through compounding.
The power of compounding: When you reinvest dividends, you own more shares. More shares mean bigger future dividends. Those bigger dividends buy even more shares. This snowball effect can dramatically grow your wealth over decades.
Growth Stocks vs Dividend Stocks
Stocks tend to fall into two categories:
Growth Stocks
- Focus on capital gains, little or no dividend
- Company reinvests profits into growth
- Examples: Many technology companies
- Higher risk, higher potential reward
- Better for younger investors with long time horizons
Dividend Stocks
- Focus on regular dividend payments
- Typically mature, stable companies
- Examples: Utilities, banks, consumer goods companies
- Generally lower risk, steadier returns
- Popular with retirees who need income
Many investors own both types to balance growth potential with income stability.
Total Return: The Complete Picture
When measuring how well your investments did, look at total return. This combines capital gains and dividends.
Total Return = Capital Gains + Dividends
Total Return Example
You bought a stock for $100. After one year:
- Stock price: $108 (capital gain of $8, or 8%)
- Dividends received: $3 (dividend yield of 3%)
Total Return = 8% + 3% = 11%
Looking only at the stock price would miss that extra 3% from dividends.
Can You Lose Money?
Yes. Stocks can also lose money in two ways:
Capital Losses
If you sell a stock for less than you paid, you have a capital loss. Using our earlier example, if you bought at $50 and sold at $35, you would lose $15 per share.
Dividend Cuts
Companies can reduce or eliminate their dividends if business slows down. This is disappointing but does not mean you lose your shares.
Important: You can lose your entire investment if a company goes bankrupt. This is why diversification is important. Never put all your money in one stock.
Taxes on Stock Profits
The government taxes your stock profits. How much depends on how long you held:
Long-term capital gains (held over 1 year):
- Taxed at 0%, 15%, or 20% depending on your income
- Most people pay 15%
Short-term capital gains (held 1 year or less):
- Taxed as regular income
- Can be as high as 37%
Dividends:
- Qualified dividends: taxed at long-term capital gains rates
- Ordinary dividends: taxed as regular income
Holding stocks for more than a year before selling gives you a significant tax advantage.
Which is Better: Capital Gains or Dividends?
Neither is universally better. It depends on your goals:
- Need income now? Dividends provide regular cash without selling
- Building long-term wealth? Growth stocks may offer higher total returns
- Want both? Many quality companies offer growing dividends AND price appreciation
The best portfolios often include both types of stocks, balanced according to your needs and timeline.
Track Your Stock Returns
Pro Trader Dashboard tracks both your capital gains and dividend income. See your total return across all your investments in one place.
Summary
Stocks make money through capital gains (selling at a higher price than you bought) and dividends (regular cash payments from the company). Growth stocks focus on capital appreciation while dividend stocks provide income. Your total return combines both. Understanding these two paths helps you build a portfolio that matches your financial goals.
Ready to learn more? Discover what a share of stock is or learn about common vs preferred stock.