Investors choose companies that they believe will see their value rise over time. The most tangible indicator of whether a company is becoming more valuable is how much it reports in stockholders' equity on its balance sheet. Let's take a look at some of the ways that stockholders' equity can increase over time.
The easy way: shareholders add more capital
When a business first starts out, its owners typically make capital contributions to get it off the ground. Sometimes, business owners lend money to their business, but typically, they also agree to make investments in exchange for their proportional ownership of the stock of the business.
This second type of capital contribution increases stockholders' equity. If an owner loans money to the business, then the liability for the debt balances out the cash the business receives as an asset, leading to no change in stockholders' equity. With a traditional capital contribution, however, there's no increase in any liability item, leaving stockholders' equity to receive the benefit of the amount of money invested.
Even once a company goes public, transactions that act as capital contributions can boost stockholders' capital. For instance, in a secondary offering of stock, the company sells shares in exchange for cash. The cash proceeds, less any expenses related to the offering, boost the company's assets and in turn create an increase in stockholders' capital as well.
The hard way: turning a profit
The other primary way that stockholders' equity changes is when the business makes a profit. However, it's not enough that the company make money. It also must choose to hold onto its profits, rather than paying them out as dividends.
For instance, say a company earns $10 million in a given year. If it pays no dividend, then its cash assets will rise by $10 million, and the company's entry for retained earnings within the stockholders' capital section of the balance sheet will have to go up by the same amount in order to keep in balance. If the company pays out a $10 million dividend, however, then its cash assets will end the year unchanged, and so stockholders' equity won't increase.
The two different ways that a company can boost its stockholders' equity have different impacts on investors. It's always better for a business to generate a profit on its own versus having to add more money in capital contributions to keep stockholders' equity moving higher.
To learn more about stocks and how to start investing, head over to The Motley Fool's Broker Center and get started today.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at firstname.lastname@example.org. Thanks -- and Fool on!