whether to issue stocks or bonds
Bonds are loans that a company must pay back. Instead of borrowing money from a bank, many companies elect to sell bonds, which are IOUs to investors. The primary disadvantage of issuing bonds compared with issuing stock, from a company’s perspective, is that the company must repay this money with interest. On the other hand, the business founders/owners don’t reduce or relinquish ownership when they borrow money. Companies are also more likely to issue bonds when interest rates are relatively low and/or if the stock market is depressed, meaning that companies can’t fetch as much for their stock.
Stocks are shares of ownership in a company. Some companies choose to issue stock to raise money. Unlike bonds, the money that the company raises through a stock offering isn’t paid back because it’s not a loan. When the investing public buys stock, these outside investors continue to hold and trade it. (Although companies occasionally buy their own stock back, usually because they think it’s a good investment, they’re under no obligation to do so.)Issuing stock allows a company’s founders and owners to sell some of their relatively illiquid private stock and reap the rewards of their successful company. Many growing companies also favor stock offerings because they don’t want the cash drain that comes from paying loans (bonds) back.Although many company owners like to take their companies public (issuing stock) to cash in on their stake of the company, not all owners want to go public, and not all who do go public are happy that they did. One of the numerous drawbacks of establishing your company as public is the burdensome financial reporting requirements, such as publishing quarterly earnings statements and annual reports. Not only do these documents take lots of time and money to produce, but they can also reveal competitive secrets. Some companies also harm their long-term planning ability because of the pressure and focus on short-term corporate performance that comes with being a public company.
Ultimately, companies seek to raise capital in the lowest-cost way they can, so they elect to sell stocks or bonds based on what the finance folks and investment bankers tell them is the best option. For example, if the stock market is booming and new stock can sell at a premium price, companies opt to sell more stock. Also, some companies prefer to avoid debt because they don’t like carrying it.
Taking a company public: Understanding IPOs
Suppose that The Capitalist Company (TCC) wants to issue stock for the first time, which is called an initial public offering (IPO). If TCC decides to go public, the company’s management team works with investment bankers, who help companies decide when and at what price to sell stock and then help sell (distribute) the new shares to investors willing to purchase them.
Now suppose that based upon their analysis of the value of TCC, the investment bankers believe that TCC can raise $100 million by issuing stock that represents a particular portion of the company. When a company issues stock, the price per share that the stock is sold for is somewhat arbitrary. The amount that a prospective investor will pay for a particular portion of the company’s stock should depend on the company’s profits and future growth prospects. Companies that produce higher levels of profits and grow faster can generally command a higher sales price for a given portion of the company.
Consider the following ways that investment bankers can structure the IPO for TCC:
| Price of Stock | Number of Shares Issued |
|---|---|
| $5 | 20 million shares |
| $10 | 10 million shares |
| $20 | 5 million shares |
In fact, TCC can raise $100 million in an infinite number of ways, thanks to varying stock prices. If the company wants to issue the stock at a higher price, the company sells fewer shares.
In the case of TCC, suppose that its stock is currently valued in the marketplace at $30 per share and that it earned $2 per share in the past year, which produces a price-earnings ratio of 15. Here is the formula: $30 per share divided by $2 per share equals a price-earnings ratio of 15.
Understanding Financial Markets and Economics
Tens of thousands of books, millions of articles, and enough PhD dissertations to pack a major landfill explore the topics of how the financial markets and economy will perform in the years ahead. You can spend the rest of your life reading all this stuff, and you still won’t get through it. The following sections explain what you need to know about how the factors that influence the financial markets and economy work so you can make informed investing decisions.
Driving stock prices through earnings
The goal of most companies is to make money or earnings (also called profits). Earnings result from the difference between what a company takes in (revenue) and what it spends (costs). We say most companies because some organizations’ primary purpose is not to maximize profits. Nonprofit organizations, such as colleges and universities, are a good example. But even nonprofits can’t thrive without a steady money flow.
Companies that trade publicly on the stock exchanges seek to maximize their profit — that’s what their shareholders want. Higher profits generally make stock prices rise. Most private companies seek to maximize their profits as well, but they retain much more latitude to pursue other goals.
Developing new and better products and services: Some companies develop or promote an invention or innovation that better meets customer needs. We have smartphones, 3D printers, electric cars, online investing through low-cost mutual funds, fast casual restaurants that can serve up healthy food at a decent price in just minutes — the list goes on and on.
Opening new markets to their products: Many successful U.S.-based companies, for example, have been stampeding into foreign countries to sell their products. Although some product adaptation is usually required to sell overseas, selling an already proven and developed product or service to new markets generally increases a company’s chances of success.
Expanding into related businesses:
