Investment Basics - Course 105 - The Purpose of a Company

By: Steve Bauer | Wed, Sep 29, 2010
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Course 105 - The Purpose of a Company


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 Course 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 firm 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.

Prof's. Guidance: Investing Wisely in "quality" companies and having an expectation of 10% - 15% - 20% or more - profits per year will perhaps make your study time a bit more worth while.

As we learned in Lesson 101, at the end of the day, investors have many choices about where to put their money; they can invest it into 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 firm 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 $1.00 that investors put into the company, the company earns $0.20 per year.

The Two Types of Capital

Before discussing return on capital further, it is important to distinguish between the two types of capital. As I 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.


Prof's. Guidance: That makes sense - doesn't it?

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, 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 could also 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.

Prof's. Guidance: You'll want to study whether or not dividends are important to you and your investment - needs, goals, and objectives. In today's stock market dividends are often very low when you take into consideration that any Company paying a dividend has a quality ranking and therefore there is considerable risk investing in a high paying dividend when it price (value) may be going down.

Different Capital, Different Risk, Different Return

Debt and equity capital each have different risk profiles. Therefore, as I pointed out in Course 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 firm 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 firm'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 only get the profits left over after everyone else gets paid. If nothing is left over, they receive nothing in return. 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. Meanwhile, loaners keep receiving the same interest payment year in and year out, regardless of how high the company's profits may reach. By contrast, owners keep whatever profits are left over. And the more that is left over, the higher their return on capital.

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 firm 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.

Prof's. Guidance: This is often confusing to unseasoned investors. How can the company be profitable and my stock is going down? Trust the old professor, that's just the way it is.

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, and the performance of a company's stock will mirror the performance of the underlying business.

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 firms 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 actual underlying business performance and 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 do so, too. And when a company's business suffers, the stock will also suffer. For example, Starbucks has had phenomenal success at turning coffee -- a simple product that used to be practically given away--into a premium product that people are willing to pay up for. Starbucks has enjoyed handsome growth in number of stores, profits, and share price. However today, Starbucks is not doing very well.

Meanwhile, Sears has languished. It has had a difficult time competing with discount stores and strip malls, and it has not enjoyed any meaningful profit growth in years. Plus, its return on capital rarely tops 5%. As a result, its stock has bounced around without really going anywhere in decades.

The Bottom Line

In the end, stocks are ownership interests in companies. I can't emphasize this fact enough. Being a stockholder is being a partial owner of a company.

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. Companies that earn low returns may get an occasional bounce in the short term, but their long-term performance will be just as miserable as their returns on capital. 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.

Quiz 105
There is only one correct answer to each question.

  1. Which of the following best defines a stock?
    1. A stock is a vehicle for speculative trading.
    2. A stock is an ownership interest in a company.
    3. A stock is a way to lend companies money.
  1. What is the purpose of a company?
    1. To take money from investors and spend it on lavish corporate expenses.
    2. To make investors rich in the fastest way possible.
    3. To take money from investors and generate profits on their investments.
  1. Which of the following is a benefit of a bondholder over a stockholder?
    1. If a company goes bankrupt, bondholders gets paid before stockholders.
    2. Bonds yield a much higher return than stocks when a company does well.
    3. If a company can't pay the interest on a corporate bond, the government will pay it.
  1. Company A generates $500 million in profits and its return on capital is 10%. Company B generates $250 million in profits and its return on capital is 20%. Which company is more profitable?
    1. Company A.
    2. Company B.
    3. They are equally profitable.
  1. All else equal, if a company's total number of shares outstanding is increasing, your ownership stake in that company is:
    1. Increasing.
    2. Decreasing.
    3. Remaining constant.



Investment Basics (a 38 Week - Comprehensive Course)
By: Professor Steven Bauer



Freshman Year

Course 101 - Stock Versus Other Investments
Course 102 - The Magic of Compounding
Course 103 - Investing for the Long Run
Course 104 - What Matters & What Doesn't
Course 105 - The Purpose of a Company
Course 106 - Gathering Information
Course 107 - Introduction to Financial Statements
Course 108 - Learn the Lingo & Some Basic Ratios

Sophomore Year

Course 201 - Stocks & Taxes
Course 202 - Using Financial Services Wisely
Course 203 - Understanding the News xxx
Course 204 - Start Thinking Like an Analyst
Course 205 - Economic Moats
Course 206 - More on Competitive Positioning
Course 207 - Weighting Management Quality

Junor Year

Course 301 - The Income Statement
Course 302 - The Balance Sheet
Course 303 - The Statement of Cash Flows
Course 304 - Interpreting the Numbers
Course 305 - Quantifying Competitive Advantages

Senor Year

Course 401 - Understanding Value
Course 402 - Using Ratios and Multiples
Course 403 - Introduction to Discounted Cash Flow
Course 404 - Putting OCF into Action
Course 405 - The Fat-Pitch Strategy
Course 406 - Using Morningstar as a Reference
Course 407 - Psychology and Investing
Course 408 - The Case for Dividends
Course 409 - The Dividend Drill

Graduate School

Course 501 - Constructing a Portfolio
Course 502 - Introduction to Options
Course 503 - Unconventional Equities
Course 504 - Wise Analysts: Benjamin Graham
Course 505 - Wise Analysts: Philip Fisher
Course 506 - Wise Analysts: Warren Buffett
Course 507 - Wise Analysts: Peter Lynch
Course 508 - Wise Analysts: Others
Course 509 - 20 Stock & Investing Tips

This Completes the List of Courses.





Author: Steve Bauer

Steven H. Bauer, Ph.D.

Steve Bauer




Steve can be reach at senorstevedrmx@yahoo.com

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