Money In and Money Out

The main purpose of a company is to take money from investors (their creditors and shareholders) and generate profits on their investments. Creditors and shareholders carry different risks with their investments, and thus they have different return opportunities. Creditors bear less risk and receive a fixed return regardless of a company's performance (unless the firm defaults). Shareholders carry all the risks of ownership, and their return depends on a company's underlying business performance. When companies generate lots of profits, shareholders stand to benefit the most.

Capital and companies, in a nutshell

At the end of the day, investors have many choices about where to put their money; they can invest it into savings accounts, government bonds, stocks, or other investment vehicles. In each, investors expect a return on their investment. Stocks represent ownership interests in companies that are expected to create value with the money that is invested in them by their owners.

Companies need money to operate and grow their businesses in order to generate returns for their investors. Investors put money—called capital—into a company, and then it is the company's responsibility to create additional money—called profits—for investors. The ratio of the profit to the capital is called the return on capital. It is important to remember that the absolute level of profits in dollar terms is less important than profit as a percentage of the capital invested.

Examples of return on capital

For example, a company may make $1 billion in profits for a given year, but it may have taken $20 billion worth of capital to do so, creating a meager 5% return on capital. This particular company is not very profitable. Another firm may generate just $100 million in profits but only need $500 million to do so, boasting a 20% return on capital. This company is highly profitable. A return on capital of 20% means that for every $1.00 that investors put into the company, the company earns $0.20 per year.