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Course 101
What Is the Purpose of a Company?


It’s funny how trivia can drown out the essentials. Think of all the emphasis pundits put on stock prices, the Dow Jones averages, this quarter’s earnings per share, and so forth. Faced with this barrage of information, it is easy to lose sight of the reason companies exist in the first place. What the heck are companies for, anyway? And what exactly are stocks?

Simply put, the purpose of a company is to take money from investors and earn a good return on it. Period. It's an investment like any other. Investors have many choices about where to put their money: They can put it into savings accounts, money-market funds, government bonds, stocks, or any number of different investments. In each, they expect a return on that investment. Stocks are merely ownership interests in companies that are expected to create value with the money they are given.

Money In, Money Out

Think of companies as machines with two spouts. Investors shovel their money—called capital—into one spout, and the job of the company is to spit money—called profits—out from the other. The ratio of the profit to the capital is called return on capital. The absolute level of profits in dollar terms isn’t nearly so important as profit as a percentage of the capital is.

Take an example. A company may have $1 billion in profits in a given year, but its return on capital might be a meager 4%. It is therefore not a very profitable company. Another firm might generate just $100 million in profits but sport a return on capital of 30%. Now there’s a profitable company. A return on capital of 30% means that for every $1.00 investors have put into the company, the company earns $0.30 in profits.

The Two Types of Capital

Back to our spouts. Two types of investors shovel their money into companies: creditors and shareholders. Creditors provide a company with debt capital, and shareholders provide it with equity capital. Creditors could be banks, bondholders, or suppliers. They lend money to the company, and in return they hope to get a fixed return on their money (in the form of interest payments). That interest rate will be higher than the return on (or interest rate of) government bonds—companies are riskier than the government—and it will be commensurate with the risk associated with the company. A steady company can borrow money cheaply, whereas a risky, unpredictable business will have to pay more.

Shareholders, by contrast, don’t get a fixed return. When a company sells shares to the public, it’s actually selling an ownership stake in itself, not a promise to pay a fixed amount each year. Instead of just a few insiders owning the bulk of the company, the insiders bring in the public as part owners; hence the phrase "going public." This practice raises money. As part owners, shareholders are not entitled to a fixed return on their shares. Like the original owners, they are entitled to the profits—if any—that are left over after everyone else (employees, top executives, creditors) gets their money.

Those profits may be paid out as dividends, in which case shareholders get cold cash. Usually, though, only some of the earnings are paid out as dividends; management invests the rest back into the company on behalf of shareholders.

Many companies, especially young ones, pay no dividends. Any profits they make are plowed back into the company. One of the most important jobs of any company’s management is to decide whether to pay out profit as dividends or to reinvest the money back into the company. Companies that care about their shareholders will only reinvest the money if they have promising projects to invest in—projects that should earn a higher return than the shareholders could get on their own.

Different Capital, Different Risk

The risks of supplying a company with capital depend on what kind of capital it is. In return for accepting a low rate of return (in the form of interest payments) on the debt capital they supply to a company, creditors shoulder less risk than shareholders. Out of the profits it generates each year, the company pays creditors first. They are first in line. Also, if the company doesn’t have enough money to pay interest, creditors can break up the company and collect the proceeds. They wield a big stick.

From the company’s perspective, then, there's a big difference between borrowing money from creditors and raising money from shareholders. If General Motors can’t pay the interest on a corporate bond, or can’t repay the principal when it comes due, it’s bankrupt. The creditors can then come in and divvy up GM’s assets in order to recover whatever they can. All that is left over after the creditors are done belongs to shareholders. Often, those leftovers don’t amount to much, if anything at all.

Raising money by selling shares is safer for a company. The shareholders only get what is left over, and if nothing is left over, they get nothing. They are the "residual" claimants to the company’s profits. The trade-off, though, is that if the company does really well, shareholders profit the most. Those debt holders just keep receiving their same interest year in and year out, regardless of what profits are. But since whatever is left over belongs to shareholders, the more that is left over, the richer they are.

Returns on Capital versus Returns on the Stock

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.

Ownership Interests

When it boils down to it, stocks are ownership interests in companies. Each share provides its holder with voting rights to elect a company's board of directors as well as to vote on certain important company decisions, such as whether or not to accept a merger offer. The more shares one owns, the greater one's voting power.

Perhaps more importantly, each share provides an ownership interest in the profits of a company. The more shares one owns, the greater this interest and the potential dividends. It's also important to keep in mind the number of shares outstanding a company may have. It's better to own one share of a billion-dollar company that only has 100 shares outstanding (a 1% ownership interest) than it is to own 100 shares of a billion-dollar company that has a million shares outstanding (a 0.01% ownership interest).

The bottom line is that stocks are just one of several types of investment vehicles, and one that represents ownership interests in companies. Being a stockholder means being a partial owner of a business.

Quiz 101
There is only one correct answer to each question.

1 Suppose two companies want to borrow $1 billion. One is a risky startup, while the other is a large, well-known manufacturer. Which company will have to pay a higher interest rate?
a. The large, established company will have to pay a higher rate.
b. The small, risky company will have to pay a higher rate.
c. There's no difference; both companies will pay the same rate.
2 Which of the following is an advantage of bonds over stocks as an investment?
a. If a company goes bankrupt, bondholders get paid before stockholders.
b. Bonds yield a higher return than stocks when a company does well.
c. If a company can't pay the interest on a corporate bond, the government pays it for them.
3 Which best describes the relationship between dividends and profit?
a. The amount of dividends paid out by a company is always greater than its total profit.
b. Dividends and profits are always exactly equal.
c. The amount of dividends paid out by a company is usually less than its total profit.
4 Total return is equal to:
a. Capital gains minus dividends.
b. Capital gains plus dividends.
c. Dividends minus capital gains.
5 What is the best definition of what a stock is?
a. A vehicle for speculative trading.
b. An ownership interest in a company.
c. A way to lend companies money.
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Copyright 2006 Morningstar, Inc. All rights reserved.
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