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Bonds vs. stocks

Learn two ways that a company can raise capital: through debt (borrowing money) or equity (selling shares). You'll also learn what a "security" is and how stocks and bonds function as different types of securities. Finally, explore some ways that a company can take on debt, and see what happens to debt and equity holders if a company goes bankrupt. Created by Sal Khan.

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  • mr pants teal style avatar for user Rachel
    Is there risk in buying bonds, or are you guaranteed the money in the future?
    (71 votes)
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    • leafers seedling style avatar for user Nathan Twining
      There can be a large amount of risk in buying bonds, in many different forms. Since you mentioned the "guarantee" part of a bond, I'll focus solely on that. The guarantee that comes with bonds is only as good as the solvency of the company or entity backing that guarantee. When you purchase a bond, you are lending your money to an entity and they are promising to pay you interest as well as give you your money back at the end of the term.

      What happens if that company goes bankrupt before you've been paid back? Well, first off there goes your guarantee. You are now a creditor against the company, essentially waiting for them to liquidate their assets or restructure. You will be first in line to receive any payments from that, but there's no guarantee regarding how much it will ultimately be, if anything.

      The risk that a company or entity will default is reflected in the "Credit Outlook" or "Rating" done by third-party auditors. This is known as credit risk ("Junk Bonds" are bonds that have a low credit rating, meaning there is a higher risk of default).
      (31 votes)
  • blobby green style avatar for user Sai Kiran Gorthi
    does a dividend mean compromise with the share value ? how does a company benefit by giving away dividends ?
    (11 votes)
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    • male robot hal style avatar for user Andrew M
      It lowers the share price, but the shareholder gets the dividend, so the total value for the shareholder is the same. If the shareholder wants to, she can turn right around and use the dividend to buy more of the same stock
      (10 votes)
  • blobby green style avatar for user barnardreflect
    Why would a company release bonds and not only stocks? Since bonds means a liability with interest on top of that needing to be paid?
    (10 votes)
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    • blobby green style avatar for user Sean
      Under the financial theories pioneered by Modigliani and Miller on the capital structure of a firm, the value of a firm can go up by adding more debt while controlling for bankruptcy and flotation costs. By targeting an "Optimal" Capital structure they can use the tax shield mentioned above to lever up their companies ROE to its share holders.

      The second reason is that by issuing more shares the company would dilute the existing share holders. The shareholders could revolt and as a result the board would terminate the management team.
      (11 votes)
  • leaf green style avatar for user Ryan
    Can Sal tell me now who loses money first? Please, he doesn't have it in the next video about shorting stock.
    (8 votes)
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    • ohnoes default style avatar for user Tejas
      The stockholder will lose money first. In fact, all the loss that the company incurs is passed onto the stockholders, unless the company goes bankrupt, in which case the stockholders get nothing, and all the assets of the company are used to pay the debtholders.
      (15 votes)
  • aqualine ultimate style avatar for user Tom
    In this video Sal talked a lot about bonds, but he also mentioned loans. Then under what conditions are loans preferred by a company and under what conditions is issuing a bonds a better idea?
    (5 votes)
    Default Khan Academy avatar avatar for user
  • marcimus pink style avatar for user SuperStarJeana
    1. Who is the company accountable to make sure they are not “fudging” (lying) what their assets and liabilities are.
    (6 votes)
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  • blobby green style avatar for user Mrinal Dasoju
    Does a company put all the money that has been left over(after we take off the liabilities from the assets) for equity ? Or it is just our decision whether to put entire left over money in the equity or only a portion of it. Where does the owner of the company make his money from. I am new to this topic, so please correct me if I am wrong.
    (5 votes)
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    • male robot hal style avatar for user Andrew M
      It's not money that's just sitting around. Assets can include cash but it also includes all the stuff a company owns. Liabilities are all the money it owes to other people. Equity is just a numerical calculation of the difference between the assets and the liabilities. There's not a pile of money lying around labeled "equity".

      The owner makes money from dividends that are paid to him by the company. The company gets the money to pay the dividends from the profits it makes. The owner also benefits from the fact that if the dividend is less than the profits, the company invests that money in additional assets to make more profits in the future.
      (7 votes)
  • blobby green style avatar for user allan roberts
    when a company stock is more expensive does that mean it is a bigger company
    (5 votes)
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    • male robot donald style avatar for user Mark Ehrmantraut
      No, size of company depends on market cap of the company
      Suppose company A whose market cap is 1 million$ and they want to divide it among 10000 shares, so value of each share will be 100$ and company B whose market cap is 10 million$ and they want to divide it among 1 million shares so value of each share is 10$, so you can see here value of share depends on companies
      (3 votes)
  • leaf orange style avatar for user ThriftyPiano
    I have noticed that in most of the diagrams Sal draws, the liabilities are greater than the equity. Does this always happen in real life?
    (5 votes)
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  • mr pink red style avatar for user Frida Zak
    What are the possible benefits the company gains from paying dividends?
    Can I judge company's reputation based on whether it pays dividends or not?
    (2 votes)
    Default Khan Academy avatar avatar for user
    • male robot hal style avatar for user Andrew M
      the company doesn't benefit, the shareholders do. And they own the company, and they want to benefit from their ownership.

      You can judge a little bit about a company by whether it pays a dividend. There's a small correlation between not paying dividends and going bankrupt. But I wouldn't use it as a primary way to think about companies, especially if you don't really know what you are doing.

      Typically a company that RAISES its dividend has a higher probability of having strong earnings growth in the next few years.
      (4 votes)

Video transcript

So we now know that there are two ways that a company can raise capital. It can do it by borrowing money, which is debt. Or by selling shares of itself, or essentially allowing other people to become partial owners of it, and that is equity. And these directly translate into securities, that you're probably familiar with, but maybe you didn't have a more exact idea of what they are. You know what equity securities are, and just so you know, what is a security? A security is essentially something that can be bought and sold that has some type of claim on something, or some type of economic value. So a security in the equity world is a stock. And a security in the debt world is a bond. Let me explain it. So let me just draw the balance sheet for the fictional company. It was pointed out to me that socks.com actually is not a fictional company. That someone is indeed selling socks online. Which, by the way, I think is a great idea. So let's see, I have my assets right here. These are the assets of the company. But that's not what we're worried about right now. And let me draw the equity of the company. This is maybe shares that they sold. So let's say that they have-- that there are 10 million shares. And then we have the debt, the debt of the company, or the liabilities. There are other liabilities other than debt, per se, but that's all we'll worry about right now. This is the debt. I'll do it in brown. We have the debt. And maybe the assets-- let me just think of a good round number-- the assets are $10 million in assets. And let's say our debt is $6 million. And then what's left over for the equity-- and the way you have to view it is OK, if I have $10 million and I owe people $6 million, what's left for the owners of the company? Well, the owners of the company will have $4 million left. And it will be split amongst the owners of the company. And there's 10 million individual shares. So every person who has one of those stock certificates will own one ten-millionth of this $4 million, or essentially, $0.40 a share, or something. So anyway, this is-- and I think you're familiar with this already-- this is essentially stock. When we say 10 million shares, that's 10 million shares of stock. I could just draw 10 million stock certificates. And, I guess, whatever the ticker symbol is. And there could be 10 million of those. Now debt is interesting. There's a lot of ways you can raise debt, and actually there's a lot of ways you could raise equity, it actually doesn't have to be with selling. Well, for the most part you are selling stock. You could maybe think of some other way, and we'll talk about other forms of equity, preferred stock and all of that. But in the simplest level, you're really always selling stock. Debt's a little different. Debt could be just in the form of a bank loan. So this could be a bank loan, where you literally go to the bank and say hey, I need $6 million, and they say OK, here you go, and we'll give it to you for this interest. And you have to pay back the money, above and beyond the interest, over this time schedule. So it's not too different than maybe a mortgage. Or they might say OK, you pay the interest for five years, and at the end of the five years you also have to pay the principal amount. So you have to pay the whole $6 million. Or you maybe have to come up with a new loan or something like that. So that would just be a bank loan. There's other things that are revolving lines of credit, which is kind of like a company's credit card to some degree, that it doesn't have to use it. But if it does, that's kind of debt the company takes on. But kind of the one that people always talk about, I guess in the same phrase, is bonds. So bonds are-- essentially you are borrowing from the public markets again. You are borrowing from a bunch of people. So what you do is you have, let's say, the $6 million. And it could be divided into-- you could divide this into 6,000 bond certificates. So this could be 6,000 bond certificates-- let me see, and six million divided by 6,000, that's a thousand, right? So it's going to be 6,000 times $1,000 bond certificates. And let's visualize what a bond certificate could look like. So that could be a bond certificate. And its face value, and sometimes they'll call it the par value, or the stated value. It'll say-- let's call it bond from Company XYZ. And it's face value is $1,000. So it's essentially-- this is an IOU from Company XYZ. If I were to hold one of these, if I had one of these sitting on my desk right now, that tells me that Company XYZ is going to pay me $1,000 at some future date. And that future date is at maturity. So it's going to pay $1,000 at maturity. And you say oh, well, Sal, that's all good, but what about the interest in between? And there's two ways to think about this. Maybe they're going to pay me $1000 in the future, but I only had to give them $500, right? So, if you think about it, there's automatically interest accruing in that. If I gave them $500 and then five years later they pay me $1000, they are essentially paying interest, right? They're paying me more back than I gave to them. And in future videos we'll actually do the math of how to figure out that type of interest. In that situation, where they're not kind of paying me interest as they go, this would be viewed as a zero coupon bond. And I know I'm throwing out a lot of terminology, but it'll all make sense to you to in a second. So zero coupon essentially means they're not paying interest until they pay off the whole loan. And then they might kind of-- the interest will be implicit in the whole value amount. And I kind of jumped the gun a little bit. But coupon is essentially a regular payment on the bond that the company makes, in this case XYZ will make, that is essentially-- you can almost view it as a kind of interest. But if you really had to figure out the interest that you're getting on the bond, you'd actually have to figure-- and I'll do maybe a whole playlist on bond mathematics-- you would have to figure out-- It's based on the coupon, what you gave them, and then what they're going to pay you, and when they're going to do it. So it's a little bit more complicated than just saying, oh, look at that, they're giving a 6% coupon, which essentially means twice a year they're going to give me 3% of the value of my bond. So just as the big picture, both of these things are traded. This is a stock, it's traded on exchange. You're probably familiar that. If you go to Yahoo! Finance, you type in the ticker symbol and you get the price for that day. Bonds are also traded. Unfortunately, it's not as easy to get a quote on a bond. Usually you have to have a Bloomberg terminal of some type. You can't get it on Yahoo! Finance, and I think that's by design, by bond traders because they probably don't like the transparency there. But it is just like a stock. It is a security. It is traded. There is a price. But then there's a very fundamental difference in what the holder of the bond is doing. In a bond, you essentially-- if I'm holding a $1,000 bond, that means that I've lent some amount of money to the company. And it'll be in this part of it. And as long as a company doesn't go bankrupt, they'll pay me some interest and pay me my money back. When I own a stock in the company, I own a share of the equity, as opposed to a share of the debt, which is the case with the bond. When I own a share of the equity, the company's not promising to pay back anything. It's just saying look, you are a part owner of this company, and anything that any of the owners get, you'll get. So if this company becomes worth a lot. If we start dividending out things to the shareholders, then you'll get that. If the company gets sold by someone and pays x dollars per share for it, you'll get that money. And if the company goes bankrupt, you'll also go bankrupt. So that actually leads to an interesting question, if the company goes bankrupt-- actually, let's do the example right now. Let's say the company goes bankrupt. And I'll do a more in-depth example of this. The question is, let's say the company goes bankrupt. And people decide that it's not operational anymore, that it just can't do business. Because there's actually two types of bankruptcy. There's one where you say, oh, the business is good, and just can't pay off it's debts. So we have to somehow restructure this side of it. And then the other type of bankruptcy is liquidation, where they say, you know what? This business doesn't even make sense to operate any more. Let's just sell off all of the assets. So the question that I'll leave you with in this video is, what happens in a situation where you enter bankruptcy? People want to liquidate the assets. And let's say when you liquidate the assets, there's only $8 million of assets. So, the question is, who do you think is going to eat that $2 million. Is it going to be the debtholders, or the stockholders? Who is going to lose their money first, or you can almost say, who is more senior when it comes to actually getting their money back? And I'll leave you with that, maybe to the next video, or a future video that I'll do on bankruptcy. See you in the next video.