It's worth repeating that when you hold a stock, you own part of a company. Part of being an owner is understanding the financial underpinnings of any given business, and this lesson will provide an introduction.
The main purpose of a company is to take money from investors (their creditors and shareholders) and generate profits on their investments. 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, at the end of the day, investors have many choices about where to put their money; they can put it in savings accounts, government bonds, stocks or other investment vehicles. In each, investors expect a return on their investment. Stocks represent ownership interests in companies that are expected to create value with the money that is invested in them by their owners.
Money in and money out
Companies need money to operate and grow their businesses in order to generate returns for their investors. 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. This particular company is not very profitable. Another company may generate just $100 million in profits but only need $500 million to do so, boasting a 20% return on capital. This company is highly profitable. A return on capital of 20% means that for every dollar that investors put into the company, the company earns 20 cents.
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The two types of capital
Before discussing return on capital further, it is important to distinguish between the two types of capital. As we mentioned above, two types of investors invest capital into companies: 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 are typically banks, mutual or hedge funds, and private investors. They give money to a company in exchange for an ownership interest in that business. Unlike creditors, shareholders do not get a fixed return on their investment because they are part owners of the company. 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 the 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).
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