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.
Shareholders are entitled to profits, if any, generated by the company after everyone else -- employees, vendors and lenders -- gets paid. The more shares you own, the greater your claim on these profits and potential dividends. Owners have potentially unlimited upside profits, but they also could lose their entire investment if the company fails.
It is also important to keep in mind a company's total number of shares outstanding at any given time. Shareholders can benefit more from owning one share of a billion-dollar company that has only 100 shares (a 1% ownership interest) than by owning 100 shares of a billion-dollar company that has a million shares outstanding (a 0.01% ownership interest).
Once a profit is created . . .
Companies usually pay out their profits in the form of dividends, or they reinvest the money back into the business. Dividends provide shareholders with a cash payment, and reinvested earnings offer shareholders the chance to receive more profits from the underlying business in the future. Many companies, especially young ones, pay no dividends. Any profits they make are plowed back into their businesses.
One of the most important jobs of any company's management is to decide whether to pay out profits as dividends or to reinvest the money back into the business. Companies that care about shareholders will reinvest the money only if they have promising opportunities to invest in -- opportunities that should earn a higher return than shareholders could get on their own.
Risks and returns
Debt and equity capital each have different risk profiles. Therefore, as we showed in Stocks 103, each type of capital offers investors different return opportunities. Creditors shoulder less risk than shareholders because they are accepting a lower rate of return on the debt capital they supply to a company. When a company pays out the profits generated each year, creditors are paid before anyone else. Creditors can break up a company if it does not have sufficient money to cover its interest payments, and they wield a big stick.
Consequently, companies understand that there is a big difference between borrowing money from creditors and raising money from shareholders. If a company is unable to pay the interest on a corporate bond or the principal when it comes due, the company is bankrupt. The creditors can then come in and divvy up the company's assets in order to recover whatever they can from their investments. Any assets left over after the creditors are done belong to shareholders, but often such leftovers do not amount to much, if anything at all.
Shareholders take on more risk than creditors because they get only the profits left over after everyone else gets paid. They are the "residual" claimants to a company's profits. However, there is an important trade-off. If a company generates lots of profits, shareholders enjoy the highest returns. The sky is the limit for owners and their profits.
Return on capital and return on stock
The market often takes a long time to reward shareholders with a return on stock that corresponds to a company's return on capital. To better understand this statement, it is crucial to separate return on capital from return on stock. Return on capital is a measure of a company's profitability, but return on stock represents a combination of dividends and increases in the stock price (better known as capital gains). The two simple formulas below outline the return calculations in more detail:
Return on Capital: Profit / (Invested Capital)
Return on Stock: Shareholder Total Return = Capital Gains + Dividends
The market frequently forgets the important relationship between return on capital and return on stock. A company can earn a high return on capital but shareholders could still suffer if the market price of the stock decreases over the same period. Similarly, a terrible company with a low return on capital may see its stock price increase if the company performed less terribly than the market had expected. Or maybe the company is currently losing lots of money, but investors have bid up its stock in anticipation of future profits or a takeover by another company.
In other words, in the short term, there can be a disconnect between how a company performs and how its stock performs. This is because a stock's market price is a function of the market's perception of the value of the future profits a company can create. Sometimes this perception is spot on; sometimes it is way off the mark. But over a longer period of time, the market tends to get it right.
The voting and weighing machines
The father of value investing, Benjamin Graham, explained this concept by saying that in the short run, the market is like a voting machine -- tallying up which companies are popular and unpopular. But in the long run, the market is like a weighing machine -- assessing the substance of a company.
The message is clear: What matters in the long run is a company's business performance , not the investing public's fickle opinion about its prospects in the short run.
Over the long term, when companies perform well, their shares will too. And when a company's business suffers, the stock will also suffer.
The bottom line
Stocks are ownership interests in companies. Over the long term, a company's business performance and its stock price will converge. The market rewards companies that earn high returns on capital over a long period.
The wealth a company creates -- as measured by returns on capital -- will find its way to shareholders over the long term in the form of dividends or stock appreciation.
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