8/20/2012 2:45 PM ET
The purpose of a company
STOCKS 105: Before you buy a business, make sure that you understand how a good business makes money for investors. Here's what you need to know.
When you hold a stock, you own a piece of a company. Part of being an owner is understanding the company's financial underpinnings.
The main purpose of a company is to take money from investors (their creditors and shareholders) and generate profits. Creditors and shareholders carry different risks with their investments, and thus they have different return opportunities. Creditors bear less risk and receive a fixed return regardless of a company's performance (unless the business defaults). Shareholders carry all the risks of ownership, and their return depends on a company's underlying business performance. When companies generate lots of profits, shareholders stand to benefit the most.
As we learned in Stocks 101, investors have many choices about where to put their money; savings accounts, government bonds, stocks or other investment vehicles. Stocks represent ownership interests in companies that are expected to create value for their owners.
Money in and money out
Companies need money to operate and grow. Investors put money -- called capital -- into a company, and then it is the company's responsibility to create additional money -- called profits -- for investors. The ratio of the profit to the capital is called the return on capital.
It is important to remember that the absolute level of profits in dollar terms is less important than profit as a percentage of the capital invested.
For example, a company may make $1 billion in profits for a given year, but it may have taken $20 billion worth of capital to do so, creating a meager 5% return on capital. Another company may generate just $100 million in profits but only need $500 million to do so, boasting a 20% return on capital. A return on capital of 20% means that for every dollar that investors put into the company, the company earns 20 cents.
The 2 types of capital
It's important to distinguish between the two types of capital that companies collect from creditors ("loaners") and shareholders ("owners"). Creditors provide a company with debt capital and shareholders provide a company with equity capital.
Creditors are typically banks, bondholders and suppliers. They lend money to companies in exchange for a fixed return on their debt capital, usually in the form of interest payments. Companies also agree to pay back the principal on their loans.
The interest rate will be higher than the interest rate of government bonds, because companies generally have a higher risk of defaulting on their interest payments and principal. Lenders generally require a return on their loans that is commensurate with the risks associated with the individual company. Therefore, a steady company will borrow money cheaply (lower interest payments), but a risky business will have to pay more (higher interest payments).
Shareholders that supply companies with equity capital include fund managers, investment banks and private investors. They give money to a company in exchange for an ownership interest. Shareholders do not get a fixed return on their investment. When a company sells shares to the public (in other words, "goes public" to be "publicly traded"), it is actually selling an ownership stake in itself and not a promise to pay a fixed amount each year.
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