The Purpose of a Company

Creditors and investors carry different financial risks with their investments, and thus they have different financial oppurtunities. Creditors bear less risk and receive a fixed return on their money. Shareholders bear a great deal of risk and their return depends on the financial success of the business. Only if the company makes a lot of money will the shareholder get paid.

As we have discussed earlier, investors have a great deal of choices where they can invest their money. In each investment vehicle, they expect a return on their money. Stocks represent ownership interest in companies that are expected to make a return on an investor's money.

Companies need money in order to operate and grow their businesses in order to generate returns for their investors. Investors put money into businesses called capital. It is the business responsibility take that money and make more money called profits. The ratio of the return to the capital is called the reutrn on capital. The absolute level of profits in dollar terms is less important than the profits as a percentage of invested capital.

For example a company may make $1 million in profits for a given year, but it may have taken $20 million to do so, that would give you a paltry 5% return on your invested capital. The $20 million is invested capital. This company is not very profitable. Another comapny may generate $1 million in profits but only $5 million to do so. This company is very profitable. That is a 20% return on invested capital. The $20 million is invested capital. That means for every $1.00 that the investors put into the company , the company earns $.20.

Two Types of Capital

Before we talk about return on capital futher, we will talk about the two kinds of capital. The two kinds of capital are debt capital and equity capital. The creditor provide the debt capital and the shareholders provide the equity capital.

Creditors are usually banks, bondholders, and suppliers. They lend companies money in exchange for a fixed return on their debt capital usually in the form of interest payments. The companies also agree to pay back the principal of the loan.

The interest rate will be higher than that on government bonds because companies have a higher risk of defaulting on the loan. The interest rates are determined by the creditworthiness of each company. A steady company can borrow at low interest rates while a new or risky company will have to pay higher rates.

Shareholders that supply the company with equity capital are usually banks, mutual funds and private investors. The give companies money in exchange for an ownership of the business. Unlike creditors they don't receive a fixed amount of return on their money. Shareholders are entitled to the profits after everyone else is paid. The more shares you own, the greater your claim on the profits and or dividends. Owners have unlimited potential profits and they can also lose their entire investment if the company fails.

If and when a profit is made, the company can either pay out some of the profits in the form of a dividend or keep the profits to plow back into the business. Dividends are a form of cash payment and reinvested profits give the shareholder the oppurtunity to recive more profits in the future. Many young companies don't pay dividends. They plow all earnings back into the company.

Debt and equity capital have different risks; therefore they have different returns. Creditors have less risk that 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 funds to cover the interest payments.

Companies understand that it is a big difference between borrowing money from creditors and raising money from shareholders. If a company is unable to pay the interest on corporate bond or the principal when it comes due, the creditors can declare the company bankrupt and come in and divide up the company's assests. If anything is left over, it belongs to the shareholders, but most of the time very little is left.

Shareholders take on more risk because they only get what's left over after everyone else gets paid. If nothing is left, then shareholders don't get anything. Shareholders have a residual claim to a company's profits. On the flip side, if a company generates a lot of profits, the shareholders enjoy the greatest returns. The sky is the limit on profits. Creditor keep getting the same money year after year. Owners get what is left over and the more that is left over the more profits the owner get.

The market often takes a lot of time to reward shareholders with a return on their stock equal to the company's return on capital. To better understand this statement, we must seperate return on capital from return on stock. Return on capital is a measure of a company's profitability, and return on stock is the measure of any dividends plus any increases in share price (known as capital appreciation).

The market frequently forgets the important relationship between return on capital and return on stock. A company can earn a high return on capital, shareholders still may suffer because of depressed stock prices. Conversely a less profitable company's share price can be bid up. It all depends on the mood of the stock market at that point in time.

In other words, there can be a big difference between a company's performance and the performance of a company's stock. That is the short term perception that the market has on the future profitability of a company. Sometimes it is right on the mark and sometimes it is dead wrong. In the long run, the market will get it right and a company's stock will mirror the performance of the company's return on capital.

The Financial Reality

Stocks are ownership in a company. Being a stockholder is like being a partial owner of a business. In the short term stock prices will fluctuate depending on market sentiment at that point in time. Over the long term, stock prices will mirror the performance of the business. If a company has good returns on capital the share price will go up. If a company does not earn a decent return on capital, the stock price will go down. The wealth a company generates by a good return on capital will find its way to shareholder in the form of dividends and share appreciation.

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