The counterpart of a stock
Before I show you
how to
detect risky stocks you have to know that every company has only two possibilities to raise or get capital. The first one was the discussed equity. If you want to take part in the ups and downs of a company you provide money to the company. Because of that you are given a certain percentage of the company, called share or stock.
What is the big advantage for the company when getting equity? Equity is risk capital that means whenever the company loses in value it doesn’t have to pay back the initial amount of money to their share- or stockholders. That’s one common reason why companies favor equity. Favor over what?
The counterpart of equity is debt capital or in short debt. This is another way how to reach new capital. What is the difference?
Well, as the name implies it is debt and thus borrowed. The company has to pay it back to the lender. So, if you decide to give capital to company X, but you don’t want to take the high risk of business fluctuations you should decide to just give a credit to X. Whether X makes profits or losses is not interesting to you. You just take your interest rates which were agreed upon from both the lender and the debtor. You are not a shareholder when lending money!
Keep in mind that this agreed interest on your credit should increase the riskier the company is. I will talk about risk assessment in the next section.
What do you think will happen if you decide to just sell your credit-position to someone else? First of all you need to find a buyer again just like it was the case when selling your shares. But suppose meanwhile the company made consecutive losses. I told before that business matters doesn’t interest you as you will get your money back plus your interest rates every year.
Do you think the new buyer would pay you 2500$? Would you pay 2500$ to take this credit over? Remember you are not buying shares!
Think a bit further and assume the company continues to make losses. When no money is earned is it possible to pay interest? Or if things sharpen to go astray don’t you think X will get problems to pay any money to its employees or to you? Therefore, business affairs bother you! So, the new buyer will if at all only pay lesser than 2500$.
You can also give credits to bigger companies who are listed in the stock market. These are called bonds. If you buy a bond of a certain company you have decided to lend money to this company. These bonds are traded every day just like stocks with the difference that their daily price fluctuations (called volatility) are less severe. Bond price fluctuations are high when looking at bonds of risky companies, just like described above when X’s business worsens. These bonds are generally known as junk bonds. |
