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Investment Basics Part I

The Company

What is the purpose of a company? Simply, a company’s purpose is to raise money from investors for a viable purpose and earn them a good return on that initial investment. This is the simplistic and more precise explanation of a company’s existence.

Generally, investors have multiple choices deciding where to put their money and receive a reasonable return on a future outlook. One option is to put their money into a savings accounts earning a guaranteed interest in return, a fund being not too dissimilar to a savings bank account however the return is more likely to vary although risks are also introduced, bonds, company stocks or any of the multitude of options available in investments. Each of these investments is an expectation of some type of positive return.

Company stock is the ownership interest in a company that is expected to create some value in the near or distant future.

The Investment

A company is in fact a money production machine having an input being the capital raised and an output being the monetary result and achievement. Investors decide on how much of their own funds they are willing to inject into the company’s business relevant to their expected return and risk profile.

An important criteria in that decision by the investor is the ratio of profit to capital which is reflected in the return on investment. The expected level of profit is not as important as much as the percentage of return on the capital is.

A simple example, say a company may have $100 million dollars in profits for a specific period generally a year, but the return on investment may only be a small percentage no greater than 5%, hence this company may not quite be a very profitable company, compared to a company which generates $100 million dollars in a single year which equates to a return on investment of 50%. The return on investment of 50% equates to $0.50 for every single dollar invested in that company.

There are two types of investors investing in a company. The creditors and the shareholders. The creditors provide a company with a debt capital and the shareholders provide the company with equity capital.

Creditors in most cases may be banks or sophisticated investors (Private investors with plenty of spare cash). They lend the company money and expect a fixed return on their investment mostly interest for banks and possibly equity (or shares) issued as payment to sophisticated investors. A company with good foresight into it’s business model is able to borrow money cheaply while a company which has relatively a higher business risk may have to pay more for the same amount sought.

Shareholders on the other hand don’t receive a fixed return on investment. A company raising capital by public offer is providing part ownership in its business with no promise of a fixed payment.

This is called going public and is the means to raise money from many people interested in investing into the venture. Shareholders being part owners of this company and it’s business are however entitled to profits, if any is left over after expenses are paid to the respective parties having interest. Profits may at times be paid to shareholders as dividends where shareholders get a cash payment as a result of any profits made. At times the company prefers to re-invest any profits back into the company as a means to expansion and future growth outlook.

Identifying Risk

Risk, fundamentally speaking is the greatest concern an investor should be considering before contemplating injecting any amount of capital into a company. From a company’s point, there exists a huge difference between borrowing from a bank and raising funds publicly. When a company is unable to repay it’s debt to the bank it is considered bankrupt. Creditors such as banks are first in line for payment, shareholders do not play a part in any payment until debt is first repaid to the creditors.

Hence a public offering in a stake of a company is regarded to being of the highest risk, there are no guarantees. From a company’s perspective any money raised through shareholders is safer long term compared to borrowing from creditors such as banks. The trade off for shareholders is that they are sharing any current or future profits and should the company be very successful shareholders are rewarded with an appreciating share price and at times with a consistent payment of dividends.

A profitable company is a company that realises a return on investment. It is important to understand a company’s profitability which is the return on capital compared to the return a shareholder receives on his/her investment.

Shareholders normally receive a dividend payment and an appreciating share price, while a company increases it’s assets. A company may earn a high return on capital, but at times shareholders could suffer due to a falling share price.

A company having a low return on its capital may see its share price rise possibly due to less negativity than the markets expectation. At times also, a company may be losing a lot of money however investors have priced the share in anticipation of future profits. The essence of this is that too often a divorce in how a company performs and the performance of the stock itself on market reference to shareholder anticipation is too distant to comprehend.

One thing to keep in mind while looking at risk over the longer term the two will converge. Normally the market in general will reward a company earning a high rate of return on its capital over the longer term.

Companies earning a low rate of return may have the occasional share price bounce however their longer term performance will play part in their current return on capital and future outlook. A company is in the business of creating wealth for it and its shareholders in the form of some measured return on investment, failing that the risk is too great and far outweighs the benefits of the original investment.

Generally speaking, a share in a company’s capital provides a shareholder with certain rights such as voting on certain important decisions from voting directors in or out or even taking part in a merger decision. The more shares owned the greater the voting power is available to the shareholder.

Shares also provide interest in the profits realised by the company, also the amount of shares owned is reflected in the amount of the interest in profits. It is also crucial to understand and know the number of shares issued in a company. As an example owning 1000 shares in a 10 Million dollar company which has 1 Million shares issued is not the same as owning 1000 shares in a 10 Million dollar company with 10 Million shares issued. An investor’s ownership of the first is seen to be a better proposition.

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