Investing in stocks? How do you measure the profitability of a firm you intend to invest in? How do firms measure their profitability? And what makes one firm a more viable investment opportunity than the other? It is simplistic to just look at the profit and loss books, because so much more goes into determining whether or not you would receive any dividends on your investment.
This post takes you through the determinant of the profitability of a firm and analyses how the owners of a firm are catered to by modern companies all over the world.
Companies have all sorts of objectives for different stages of their growth and various departments and operations but it is a known fact that a firm’s primary goal is to maximise the wealth of its shareholders.
Types of Companies
Legally, firms take one of three forms, and the form in which a business is legally registered affects three key aspects of the company;
- How the firm acquires investment capital
- How much taxes the firm will pay on its profits
- The level of risks borne by the firm’s owners
The most familiar business form is a sole proprietorship. Often, all of the firm’s profit goes to the owner or proprietor; the same applies to the firm’s losses. This is referred to as unlimited liability. It means the owner can be forced to pay the firm’s debts from their personal wealth.
Capital for a sole proprietorship business is often raised by the owner from personal funds or by borrowing from friends or family, making the proprietor the only or main shareholder of the firm. The business’s decisions are taken without consulting anyone. This kind of business is easy to fold up, and the company starts and ends in its proprietor’s life.
This is a form of business with more than one owner. Like the sole proprietor, the partners have unlimited liability to the firm’s debt, and each partner’s income is taxed on their tax return. The thing with partnerships is that partnerships are almost non-transferable. Also, the owners have to cover the other partners’ debts, and the partnership ends when any of the partners dies. A partnership can raise more funding than a sole proprietorship.
An interesting feature of corporations is that they are established by law and vested with legal powers. This means a corporation can be sued, and it can sue other entities or individuals. Even though corporations pay more taxes and are more expensive to run, they also can grow into large companies through a sale of ownership by floating shares.
Who are the Stakeholders of a Firm?
A firm’s stakeholders include everyone who has an economic interest in the firm, like its owners, employees, customers, suppliers, and creditors. Some firms do well to be stakeholder-focussed; they do this by consciously avoiding any actions that could adversely affect its stakeholder. This does not change the firm’s primary goal to maximise its shareholder’s wealth, but it only seeks to preserve the stakeholder’s well-being.
Stakeholder-focused firms acknowledge that to maximise their shareholder’s wealth better, they would have to foster cooperation with their stakeholders. The firm can do this through its corporate social responsibilities (CRM), which it can use to maintain a positive relationship with its stakeholders by minimising conflicts and political frictions.
Who are the shareholders of a firm?
The owners of a corporation enjoy limited liability; if the corporations collapse, its owners lose just what they invested into the company. These owners are stockholders (individuals and entities) who have purchased the corporation’s stocks, expecting to receive periodic returns in the form of dividends as the company makes more and more profit. Stockholders’ equity can also increase if the company’s share price is increased.
The board of directors of a corporation is individuals elected by the stockholders of the corporations primarily to manage their interest, as the real owners of the corporation. The board of directors then hires the company’s CEO and managers.
Who are residual claimants?
The term residual claimant is used to describe the stockholders of a corporation. It means you will be the last to be paid. The company pays its employees and suppliers. Then it pays its taxes and lenders. The stockholders are then paid if there is still more money.
Since the stockholders elect the company’s board of directors, one can easily see how they can see the management as ineffective if no dividends are paid year after year. If this continues for a long period, the stockholders would be more ready to sell off their stocks even if it would be at a loss, and this could cause the company’s share price to fall. This eventually negatively impacts the company’s ability to raise capital for any kind of investment operations.
On the other hand, if the company keeps making enough profit to pay dividends, its share price increases as more and more investments become interested in acquiring its stocks.
Therefore, it is safe to say that the firm’s continuity is determined by maximising its shareholder’s wealth. This statement is true whether the firm is a sole proprietorship, a partnership, or a corporation.
How do firms maximise investors’ wealth?
As an investor or shareholder, you should be interested in how the firm intends to compensate you for your money. The shareholder’s wealth can be quantified in the price of the company’s stock. This can increase as more and more attractive dividends are paid to the stockholders. And this can happen after the company has met its internal obligations. This means that in satisfying the companies’ shareholders, employees would have to be well taken care of to reap high customer service and satisfaction.
The managers of the organisation have the responsibility to make decisions that increase the shareholder price. They can do this by assessing the net cash inflows and outflows every action they take would bring.
Why profit maximisation is different from wealth maximisation
Corporations measure their profitability in terms of earnings per share (EPS). It is computed by dividing the period’s total earnings available for its common stockholders by the number of yet unpaid shares of common stock. This is done because it can be erroneous to assume that maximising a firm’s profit is equivalent to maximising its share price for the following reasons;
1. How Cash flows affect investor’s wealth
A firm can make a profit alright, and yet, for some reason, the board of directors might reduce to increase its stockholder dividends. Then also, computations of profit vary sometimes, depending on the accounting techniques adopted by the firm. The books could show that the firm has made a profit, and yet the total cash outflow may exceed its cash inflows.
Also, a firm’s investors could anticipate a low future share price if they’re aware of management decisions, which may increase share price.
For instance, if the firm goes into the production of a once-off opportunistic good, its share price may increase due to the high returns it makes. Still, the investors can predict the end of that market and quickly rush to sell its shares, thereby causing a reduction in the share price.
2. How a firm’s risk-level affects its shareholders’ wealth
Accounting profits fail to factor in the level of risk associated with an investment, and therefore, one more reason why the stock price is a better way to access companies. Even though the return on investment is a key determinant of share price, there is a trade-off between return on investment and risk.
High returns mean higher share price, and higher risks also mean lower share price. This means that even though a profitable firm would maximize shareholder wealth by increasing share price, a lower share price could also indicate high risk. A firm can be profitable, yet its share price would likely suffer if investments deem its operational environment an investment risk. An example of this is when in 2011, Apple stocks suffered when Seve Jobs was taken ill.
3. How time affects a firm’s investors’ wealth
A firm could be profitable yet pay fewer dividends to its stockholder and choose to reinvent larger portions of its profit. This makes the firm even more profitable, and yet its stock price may be suffering.
Investing in stocks: Conclusion
In conclusion, firms exist primarily to maximize their shareholders’ wealth alright, but to do this effectively and in the long run, it has to foster cooperation with its stakeholders. Understanding this will help you in determining your best investment options.