ood question indeed. Why do people buy shares?

In a line: Because they can make big money on it.

There's a huge difference between the gains and losses you can make by investing in the stock market as compared to your returns from bank fixed deposits.

In stocks, you can make unbelievable money -- it's not uncommon for people to have doubled their money in the last one year.

On the flip side (there is always one), when the markets crashed in May, many people lost more than a quarter of their investment.

Compare this with your bank fixed deposit. Your FD will only fetch you around five to six percent per annum, but you can be sure of getting your money back.

When you put your money in a bank deposit, you loan the money to a bank for a fixed return (rate of interest) and a fixed tenure (number of months or years). At the end, you get back your original amount and you are paid interest on the same.

When you invest in stocks, you do not invest in the market (despite what you think). You invest in the equity shares of a company. That makes you a shareholder or part-owner in the company.

The good news is that since you own a part of the assets of the company, you are entitled to a share in the profits those assets generate.

The bad news is that you are also expected to bear the losses, if any.

Now, if you are a shareholder, there are two ways you can benefit from the profits of the company: capital appreciation or dividend.

Dividend

Usually, a company distributes a part of the profit it earns as dividend.

For example: A company may have earned a profit of Rs 1 crore in 2003-04. It keeps half that amount within the company. This will be utilised on buying new machinery or more raw materials or even to reduce its borrowing from the bank. It distributes the other half as dividend.

Assume that the capital of this company is divided into 10,000 shares. That would mean half the profit -- ie Rs 50 lakh (Rs 5 million) -- would be divided by 10,000 shares; each share would earn Rs 500. The dividend would then be Rs 500 per share. If you own 100 shares of the company, you will get a cheque of Rs 50,000 (100 shares x Rs 500) from the company.

Sometimes, the dividend is given as a percentage -- i e the company says it has declared a dividend of 50 percent. It's important to remember that this dividend is a percentage of the share's face value. This means, if the face value of your share is Rs 10, a 50 percent dividend will mean a dividend of Rs 5 per share (See What's in a share? Money!).

However, chances are you would not have paid Rs 10 (the face value) for the share.

Let's say you paid Rs 100 (the then market value). Yet, you will only get Rs 5 as your dividend for every share you own. That, in percentage terms, means you got just five percent as your dividend and not the 50 percent the company announced.

Or, let's say, you paid Rs 9 (the then market value). You will still get Rs 5 per share as dividend. That means, in percentage terms, you got just 55.55 percent as dividend yield and not the 50 percent the company announced.

Capital Gain

As the company expands and grows, acquires more assets and makes more profit, the value of its business increases. This, in turn, drives up the value of the stock. So, when you sell, you will receive a premium over (more than) what you paid.

This is known as capital gain and this is the main reason why people invest in stocks. They want to make money by selling the stock at a profit.

It is not as easy as it sounds. A stock's price is always on the move. It could either appreciate (increase in value) or depreciate (decrease in value) with respect to the price at which you purchased it.

If you buy a stock for Rs 10 and sell it for Rs 20 after a year, then your return from that stock is Rs 10, or 100 percent.

Or, if you buy a stock for Rs 10 and sell it for Rs 9, you lose Rs 1, or your loss is 10 percent.

Now look at both: Dividend and Capital Gain

If you buy a stock for Rs 10 and sell it for Rs 20 after a year, then your return from that stock is Rs 10, or 100 percent.

Add the Rs 5 per share you have received as dividend, and your total return will be Rs 10 plus Rs 5 = Rs 15 or 150 percent (Rs 15 divided by Rs 10 multiplied by 100).

If you buy a stock for Rs 10 and sell it for Rs 9 after a year, you would lose Rs 1 per share.

However, you would have got Rs 5 as dividend. So you would net Rs 4 as earnings from the company.

In percentage terms, your return would be 40 percent (Rs 4 divided by Rs 10 multiplied by 100).

Tax

One last point.

If you are a tax payer, the finance minister has made it very easy for you to invest in the stock market. There is no tax on dividend. Neither will you be taxed on long-term capital gains. This means, if you buy a share, hold it for at least a year and sell it at a profit, you don't have to pay any tax on the profit your make. If you sell it within a year, the short-term capital gains tax is only 10 percent.

Contrast this with fixed deposits, where you have to pay tax on the interest at your marginal tax rate. This means that, if you are in the 30 percent tax bracket and your interest income exceeds Rs 12,000 in a year, you'll have to pay tax on your interest income at that rate (including the surcharge, the cess, etc, the rate works out to almost 35 percent).

Investing in stocks may be more risky, but it is more tax-friendly. Besides, there is the potential to get a higher return on your investment.

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What's in a share? Money

Image: Rajesh Karkera