Hi, I'm Jeff. And in this lesson, we'll learn how companies can use equity for financing and how this involves an initial public offering. So let's get started.
What is equity financing? This is a method of financing through the selling a portion of ownership interest. Ownership interest often occurs when a corporation issued stock that can be purchased as a stake in the company.
The first time a stock is offered to the public is called an Initial Public Offering or IPO. These are excellent ways to raise a significant amount of money. But public offerings are expensive to setup and time-consuming due to the regulations surrounding public equity markets.
Each person who purchases stock in a company is known as a shareholder. Since they own shares of the company, shareholders invest in equity, because they hope to be able to earn money, either through an increase in the stock price or through the payment of dividends. A dividend is the moneys paid on a routine basis to shareholders from the profits of a company. They are distributed on a per share basis.
For example, if a company pays a $0.25 dividend, then for every share of stock that you own, the company would pay you $0.25. The current price of a stock on an open market is known as the market value. If a shareholder chooses to sell their stock after an increase in market value, then the profit earned on the sale is known as a capital gain. This is the difference between the price at which the stock was bought and the price at which it was sold.
For example, if you purchase a stock for $8 and sell it for $13, then the capital gain is $5. There are two types of stock that can be issued by a company, common stock, which is the most basic type of stock. Most shareholders have this type of stock. And these owners are paid out last during any dividend dispersion or financial failure. And they only have voting rights on major issues.
The other type of stock is preferred stock. This is a safer form of ownership, since these owners have priority and dividend payments. However, owners of this stock can also be forced to sell back this stock to the company. And the shares do not have voting rights.
When calculating the profit a company makes before dividends are paid out a company may retain earnings. Retaining earnings is the moneys held from net income to be used by the corporation as opposed to disperse to shareholders. Higher retained earnings means lower dividends to shareholders and may cause a decreased demand for the stock or a decrease in stock market value. A company that is reinvesting retained earnings is often considered attractive to investors though, since the company is confident enough to invest in its own growth.
Finally, let's talk about earnings per share. This is the financial value of each individual share of a common stock. This is calculated by taking the net income of the company and dividing it by the number of outstanding shares. For example, if a company makes $1 million in net profit and they have $2 million outstanding shares of stock, then the earnings per share would be $1 million divided by $2 million or $0.50 earnings per share.
This ratio measures the earning power of the company in relation to the amount of equity financing it is used to create those earnings. As such, it indicates to investors the potential for profit based on a single share. OK, nicely done.
In this lesson, we learned about equity financing. We talked about shareholders and how they profit from stock ownership. We discussed the two types of stock, and we reviewed retained earnings and earnings per share as values that investors consider when evaluating a company. Thanks for your time, and have a great day.