Equity vs. debt | Stocks and bonds | Finance & Capital Markets | Khan Academy


Everything we’ve talked about
so far with this startup company selling socks and all
of that, has been raising money from an equity. We raised private money– when
the company was private it went to VCs and it went to angel
investors, and maybe you could go to your friends and
family to raise money. And then the company could go
public and raise money from the public markets. But there’s actually
two ways that a company can raise capital. So this is why this playlist is
called capital markets, or it’s part of it, the name
of raise capital. Capital is just essentially–
I mean the easy way to think about it is you’re raising cash
that you want to invest in some way to grow your
business or to sustain your business or start
your business. So everything we talked about so
far was equity, and that’s essentially selling shares in
your company to raise money. And so that’s all of
those VC examples. The equity investor– so when
you sell equity, you’re essentially selling– you’re
kind of making that person who’s buying the stock– you
know, an equity is the same thing as stock– you’re making
the person who’s buying a stock kind of a partner
in the company. So if the company– let’s say
there’s two situations– if the company goes bankrupt– and
I’ll talk a lot more about what bankruptcy even means–
but if the company goes bankrupt, all the shareholders
end up with nothing. They end up with nil. But if the company has a lot
of upside, the stock gets a lot of upside. Because they’re partners
in it. If this was a company, that
start-up that we talked about, if it turns into Amazon.com and
becomes a billion-dollar company, everyone is going
to do really well. Everyone’s going to share
in that upside. But there’s another way to raise
money, and actually this is probably something that’s
more familiar at the household level. I mean at the household level
you never raise equity. You never say, you know what–
well you can, but you’re not going to say hey, I need to buy
a house, why don’t I go to my rich friend and offer to sell
10% of the stake in my house to him and he’ll be kind
of a partner in my house. That could happen but for the
most part it doesn’t. Usually when you do something on
a personal level you raise money through debt. And that’s interesting. So what’s good about debt is
it’s– so let’s think about it from the point of view of
the person who’s lending the money to you. Debt is just borrowing money. I think all of us know what
borrowing money is. I go to my rich friend and I say
hey, could I borrow $1 and I’ll give you $1.25 in a year? And he says, OK, you’re
good for it. But I’m essentially promising
I’m going to give the money back at some future date. If I sell equity, I’m not
promising anything. I’m like hey, I got a great
business, why don’t you give $1 and then you get a 20%
cut of my business. If my business does awesome,
you get 20% of all of the profits of my business. If my business does horrible,
well you took a risk, you get nothing and I get nothing. Debt says regardless of how my
business does, if it does awesome all you’re going
to get is the interest. That’s kind of the upside. So the upside’s limited,
right? If I borrow money at 9%
interest, all that person’s going to get is 9%. Even if my company becomes the
next Google or Microsoft or whatever else, that person’s
just going to get 9% on their money. While this person might have
gotten a hundred times their money because they made a bet. On the other hand, this downside
is much lower. So limited downside. Because they’re going to get
their money back at a certain– you know, there’s a
certain payment schedule. And they’re going to get their
money back before the stockholders– so let’s say
in a situation where the company’s going into
difficulty– and we’ll do a whole playlist on bankruptcy–
the people who lend money to the company will see their money
before the stockholders see anything. So how does all of this come
out from the balance sheet? So let’s say we have
a public company. If you wonder what a CFO at a
company does, this is really the main decision that they’re
always making. Do we raise money– well, how
do we raise money if we need it, and do we raise money from
the equity markets or from the debt markets? So let’s come up with
a company again. Let’s say that that’s
its current assets. Not current– I don’t want to
say current assets, it’s the assets that it currently has. Current assets means something
different, and we’ll talk about that in the future. But let’s say, so that’s
its assets. You know it might have
some cash here. We’ll go into more detail. We’ll actually look at real
company balance sheets and decipher what all of the terms
on the balance sheet mean. But that’s its assets for now. And let’s say right now all of
its money it’s raised so far has been equity. And let’s say it’s a publicly
listed company. It doesn’t have to be. Let’s say that’s all of its
equity, and let’s say it has, I don’t know, 10
million shares. And the other interesting thing
about when a company’s public– remember, every time
when a company was private and it took an investor, when it
took equity investors, they had to sit and have a
negotiation saying what is this worth? What are these assets worth? But what’s cool is, is when
you have a publicly traded company, these shares are traded
on an exchange, right? These shares are on, let’s
say it’s on the New York Stock Exchange. So every day you could
go to Yahoo! Finance or wherever and you
can look at a chart. Let me draw a chart. You can draw a chart. And we’ve all seen stock
charts, I think. So let’s say that this is this
could have been its IPO date or it could just be the start
that we’re looking at, and let’s say the stock IPO went up,
and then the whole market went down a little bit. But the stock– maybe
it’s there, right? But on any given, really almost
any given second, there’s a price that somebody
traded that stock at and it might not be the best price,
but it is a price. And we’ll talk about why that
happens, because you might have 10 million shares, and if
only, I don’t know, 100 shares get traded at any second, or
let’s say only 100 shares get traded in the day, is that
an indicative price? Because that’s not
a huge percentage of all of the shares. But anyway, we’ll talk more
about what volume means relative to the total float
and all of that. But let’s say at this split
second the company shares traded at $15 a share. This is $15, right, at
this second in time. This is like right now. Traded at $15 a share, and you
could look it up on your Bloomberg terminal
or whatever else. So essentially the market
is providing us a value for this company. The market is saying wow, the
market is willing to trade the share at $15. There was a willing buyer and
a willing seller at exactly $15 a share. So that means that the market at
that moment is valuing this company at $15 per share times
10 million shares. So $15 per share times 10
million shares– not necessarily a dollar sign. So the market is assigning
a, 15 times 10 is 100. $150 million market cap. Market capitalization
for the company. And you could look on the kind
of, I think it’s the key statistics tab on Yahoo! Finance, and you’ll see market
capitalization for a company. And it’s just the number
of shares times the price of the shares. This is essentially what
the market’s value of the equity is. The market is saying that
this piece right here is worth $150 million. And since this piece is the same
size as the assets, we have nothing else on the
right-hand side, the market’s essentially saying that the
assets right now are worth $150 million. And these aren’t always
going to be equal. We’ll see probably in a few
videos when you start raising debt you have to do an extra
calculation to figure out what the asset value or– and I’ll
throw out a new term here, the enterprise value
of the firm is. The enterprise value’s
essentially the asset value minus excess cash. The cash the company really
doesn’t need to operate. And we’ll go into more
detail of that. But we’ll just view it as
the assets for now. So if I’m the CFO of this
company, and let’s say we need to raise another, I don’t
know, $15 million. I have two options. I could say OK, the company is
trading at $15 per share, I need to raise $15 million,
so I could issue another million shares. It wouldn’t be the initial
public offering because I’m already public. It would be a follow-on
offering, or sometimes it’s called a secondary offering. Although the word secondary has
kind of two connotations. But it would be a follow-on
offering where I would issue, I’d go to the board, we would
essentially create another million shares, and then sell
them into the market, and hopefully people will buy it at
$15 a share or probably a little bit less because we’re
kind of flooding the market with a ton of shares. Maybe they buy it at $14
per share, and we would raise $14 million. And that would be a follow-on
offering. So we can always use the public
markets as a way to raise more money. We didn’t have to go to all
this– I mean, for the most part we didn’t have to do this
huge valuation exercise and negotiations and do all of this,
hire banks and all that. Although the banks will
still collect fees. We actually would have to
hire banks to do this. So that’s one option. Or the other option is we’re an
established company, we’re generating cash, we could
make interest payments if we want to. We could go to a bank. And actually there’s a lot of
different ways to do this. But we could essentially
borrow money. And let’s just say we do that. Instead of doing this–
let’s say we do both. So let’s say we did a $1 million
follow-on offering, that gave us $14 million. And let’s say we want another
$2 million, but this time instead of selling shares–
so right now how many shares do we have? We sold 1 million, we
had 10 million, we have 11 million shares. Let’s say, you know what, let’s
say as a CFO I feel like our shares are going to
move up a lot more. So we don’t like selling
them at this low price. And let’s say interest
rates are really low. Instead we’re going
to borrow money. That’s essentially
raising debt. So let’s say we borrow another
$3 million because we need it. So actually this would be debt,
$3 million of debt, and we would get $3 million
of cash. So now our assets are
all of this stuff on the left-hand side. And what are our liabilities
now? Now, we didn’t have liabilities
before because everything we had
were equities. But now we do. Now we owe somebody $3
million right here. And I’ll talk more about all the
different ways to kind of borrow money. But it’s essentially, it could
just literally be a bank loan. They might have just gone to
Bank of America and said hey, we’re a big company and we’re
good for the money, why don’t you lend us $3 million. And maybe it would be $3 million
at a low interest rate, at maybe 6% per year. And Bank of America feels good
because you have a high– we’ll talk more about credit
ratings and all of that– but they say oh, you have
essentially a good company credit score. So we’ll give it to you at
a low interest rate. So what happens in the future
is, these assets are going to generate, hopefully,
some cash. And before these guys see it–
let me do to it in the– before these equity holders–
this is the equity holders right now– before the equity
holders see anything, these guys have to get paid their
interest. And I’ll show you all of that on a line-by-line
basis in an income statement. Everything we’ve done so far
has been a balance sheet. But something interesting
is happening now. Now all of a sudden your assets,
which is that side– I know I just keep writing over
the same drawing– your assets are now larger than
your equity. I think now, and this is just
kind of a review of the balance sheet video, you see
that the assets are equal to your equity, which is this right
here, your equity plus your liabilities. Your liabilities now
are $3 million. Plus liabilities. So if you wanted to know what
your assets are worth, because your assets are equal
to your equity. So what’s your market value
of your equity? Well, we figured that
out already. We have 11 million shares now. And let’s say the stock plummets
to $10 a share for some strange reason or for
a not-strange reason. So what’s the market cap? $10 a
share, 11 million shares, we have a $110 million
market cap. We’re doing a market value. And we’ll talk more about the
difference between market and book value. But this is the market
value of your equity. And then what is your
liabilities? Well we owe $3 million,
so plus 3 million. So we could say that for the
most part the market value of our assets, the market thinks
that this entire left-hand side is going to be worth the
value of our equity, the market cap of the company, plus
the amount of debt, which is equal to $113 million. So the value of these assets are
$113 million, and that for the most part is the enterprise value of the company. What is the company’s
assets worth? And we’ll talk– there’s a
little bit of a tweak we’ll do in the future on enterprise
value. But that’s essentially how you
kind of can value what the company’s worth. A lot of people when they do
a market capitalization calculation they say
oh, that’s what the company’s worth. Well no, that’s what the
equity is worth. Market cap is what the
equity’s worth. If you want to know what the
company’s worth, you have to take the market cap and
then add the debt. Another way– well, I won’t get
too complicated because I just realized I’ve run
out of time again. See you in the next video.

66 Replies to “Equity vs. debt | Stocks and bonds | Finance & Capital Markets | Khan Academy”

  1. I think Sal should do a video on what he feels is the best way to end this crises if he were president. I'm wondering if he feels that building new bridges, roads, and increase government spending on education will trigger enough capital to get the world out of this mess we're in. Or does he think starting a war like we did after the Great Depression will be the best solution.

  2. Awesome video! Khan easy to understand analysis makes it easy for us Laymans to understand! Cant thank you enough for making the complicated simple.. mark of a true genius! 🙂

  3. @YourLordliness

    Stocks shouldn't have been invented. Non-tradable long-term bonds make much more sense for a capitalist system. Investment fuels capitalism. Trading whores it. If bonds must be traded, only creditors should (i.e. by trading the bond principal and bond maturity date).

    Normal economics chants that thinking on the margin indicates rationality. I say rationality cannot be rushed. I also say that whoring a living from the economy is irrational. Who agrees with me?

  4. @georgebushsen

    "investment and finance is the heart of capitalism it's all about these two things"

    Of course, but that does not mean we should all be naked short sellers, or that naked short selling should be financially encouraged.

  5. @georgebushsen Trading is definitely NOT creating value. It's supposed to be the most efficient method of allocating capital to productive companies. It's become a bullshit game that exists on it's own, but never confuse that with actual contribution to society.

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  7. thanks it really make the calculation easy,,,,for calculating the asset is it right as stated above to add the numbers of shares to the borrowed money or the the worth of share to the borrowed money to the total asset????

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  12. Good examples! I would consider something like low risk stocks which provide a good yield wellsbee.com provides for good stock picks in the current market.

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  14. the fact i use your videos to teach me stuff (and im in university) says something about the education system. Your videos are amazing and you help hundreds of thousands of students thank you!

  15. do you guys like the classroom feel of this? cuz as pure educational video, it's kinda shitty. here's why I think so. 1. script what you're gonna say. write it down then read it. It will sound nothing like this. 2. why the f is he writing free hand? so it simulates a blackboard? that's retarded.

  16. hi i am starting a company with a friend. i am asking how do we decide on equtiy n debts? how we agree on share capital for both us before bringing in investors?

  17. Seek for help!!!I am new to finance. I get the difference between quite vs debt now, but it sounds similar to the relationship between bonds vs share. Am I right? What is the differences between these two pairs of words??

  18. why does increasing debt increase the value of your company? in other words, why isn't the company's value lessened by debt?

  19. i want to get some stock money but I don't believe it until I know exactly what's all about you're very good at explaining I just wish I could really get the whole game.. I feel nervous but hoping for beginners luck

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  22. but what if the companies assets fall drastically in value? So if the $150 million had been used to make a rocket that was now obsolete and only worth $50 million. how would that effect market cap? or say the rocket was worth only $1 million and there is the $3 million debt – surely then the company is bankrupt?

  23. I wonder how is it possible that you can teach every thing and in such a nice way, your are wonderful man.

  24. Dear Mr Salman, I don't know how to appreciate your wonderful job, I only can say that I wish there were more people like you on the world.

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