Course 101: What Is the Purpose of a Company?
Returns on Capital versus Returns on the Stock
In this course
1 Introduction
2 Money In, Money Out
3 The Two Types of Capital
4 Different Capital, Different Risk
5 Returns on Capital versus Returns on the Stock
6 Ownership Interests

It’s always crucial to separate how profitable a company is—the return it makes on capital—versus the return shareholders actually get, which is a combination of dividends and increases in the stock price (known as capital gains):

Shareholder total return = capital gains + dividends

A company can earn a high return on capital, but its shareholders could still suffer if the market price of the stock drops. Likewise, horrible companies with low returns on capital may see their stocks shoot up in price, possibly because the company simply did less horribly than the stock market had expected. Or maybe the company is currently losing lots of money, but investors have bid up its stock in anticipation of profits in the future. In other words, there is often a disconnect between how a company performs and how its stock performs.

Over the long term, however, the two will converge. The market rewards companies that earn high returns on capital over time. Companies that earn low returns may get an occasional bounce, but their long-term stock performance will be just as miserable as their returns on capital. The wealth a company creates—as measured by returns on capital—will, over the long term, find its way to shareholders, either through dividends or stock appreciation.

Next: Ownership Interests >>


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