So you’ve got extra money and you don’t know what to do with it? Congratulations, it’s a great problem to have! In this article we’re going to look at the two main ways to invest in companies; through purchasing their shares or bonds. Let’s figure out what they are exactly.
The Balance Sheet
Funky Toga Store’s Balance Sheet
A balance sheet is a way to represent what a company owes and owns. On the left-hand side is what a company owns. The Funky Toga Store has $20 of cash and $70 worth of togas sitting in the store. On the right-hand side is what a company owes. The Funky Toga Store owes the bank $40 in the form of a loan. The remaining $50 is what the store owes to its owner, in other words the value of the owner’s stake of the business.
Let’s say that the Funky Toga Store needs to raise money to buy more togas. It writes on a piece of paper “I promise to pay the bearer of this note $110 in one year’s time” and sells the piece of paper to an investor for $100. This is a promise-to-pay known as a bond. The balance sheet now looks like this:
The store owes the investor $110 in one year’s time (equivalent to $100 today) which is recorded on the liability side. It receives $100 cash which is recorded on the asset side.
In financial markets companies, governments and banks all issue bonds to raise money. They are simply promises-to-pay which are auctioned off for cash in the bond market. The investor that purchases the certificate can then either hold it until maturity (i.e. when the bond issuer has to pay back) or sell them to other investors before that time.
Let’s say that the owner of Funky Toga Store wants to take on a partner, and he agrees to sell a half of his share in the store to his brother. He gets fifty sheets of paper and writes “This certificate entitles the bearer to one share of the Funky Toga Store”. Since there are fifty sheets of paper and the total owner’s equity is worth $50, each share is worth $1. The owner can then give 25 (half) of the sheets to his brother. When he does so the balance sheet of the Store remains the same; there is still $50 Owner’s Equity outstanding, it is just split between two people. Shares are also known as stocks or equities.
In financial markets, investors frequently buy and sell shares. They are really trading tiny ownership stakes in a given company. The value of the shares will go up and down depending on how profitable investors think the company will be in the future.
Shares versus Bonds
Bonds and shares are the two main ways to invest money into a company. So which way should you choose? It depends on how much risk you want to assume. Let’s look at how much you’ll earn by investing in the Funky Toga Store with either bonds or shares in a few different scenarios.
Firstly, let’s say that Funky Toga Store has done really well:
After subtracting the the cost of the togas sold, the store made $100! The interest on the bond (and the bank loan) is paid out at a fixed percentage, which works out to be $4 and $6 respectively. After paying tax there is $63 leftover to be distributed equally to all 50 shares. The two brothers, who have 25 shares each, will be entitled to $31.50 (known as a dividend payment). Cue Frank Sinatra singing “it was a very good year…”.
Secondly, let’s suppose that the Funky Toga Store had a tougher year. The cloth that the togas are made of went up in price but the store continued to sell them at a reliably low price, so the operating income is vastly reduced. Despite the worse performance, the bank and the bondholder still received their fixed interest payments. It is the owners who bear the consequence of the store’s under-performance, they get only a $3.50 dividend each.
Finally, let’s suppose that Funky Toga Store did terribly. They started to manufacture togas from cashmere but forgot to raise the price. Even though they made a loss they are still required to pay interest on both the bank loan and the bond, which they did out of the store’s savings. There is no money to pay a dividend to the brothers and the loss will cut into the store’s savings, reducing the value of the owners’ stake in the business.
So, the difference between a bond and a share is in the priority of repayment. A bondholder gets an agreed percentage in interest, and he or she is always paid before any owner. A shareholder gets whatever is left over. In a good year this may be a fantastic pile of money, but in a bad year they could easily earn nothing. The shareholder takes on more risk, which means he or she should expect greater return.
I have used the terms owners and shareholders interchangeably here, they are one and the same. Owning shares in a business will also usually entitle the holder to a say in how the business is run. If you own a half share of a small store this will be more direct than if you have one share in a large, publicly-listed company, but in both scenarios you have rights as a part-owner.
Bonds and shares are the two main ways to invest in a business. In the former you are lending money to a business at an agreed interest rate and you will be first in line for repayment. In the latter you are taking an ownership stake in a business, and so the amount of repayment depends heavily on the performance of the business. These distinctions are essential when we discuss investment options in later articles!
Oliver is a banker who has an ambition to help millennials learn the adult skills they never got taught. To follow his journey head to his medium page here.
If you have questions then please email or comment and Oliver will do his best to answer.