Equity

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What is 'Equity '

Generally speaking, equity is the value of an asset less the amount of all liabilities on that asset. It can be represented with the accounting equation: Assets -Liabilities = Equity.

BREAKING DOWN 'Equity '

Equity can have somewhat different meanings, depending on the context and the type of asset. In finance in general, you can think of equity as one’s degree ownership in any asset after all debts associated with that asset are paid off. For example, a car or house with no outstanding debt is considered entirely the owner's equity because he or she can readily sell the item for cash, and pocket the resultant sum. Stocks are equity because they represent ownership in a firm, though ownership of shares in a public company generally does not come with accompanying liabilities.

The following are more specific definitions for the various forms of equity:

1. A stock or any other security representing an ownership interest. This may be in a private company (not publicly traded), in which case it is called private equity.

2. On a company's balance sheet, the amount of the funds contributed by the owners (the shareholders) plus the retained earnings (or losses). Also referred to as stockholders' equity or shareholders' equity (see below).

3. In the context of margin trading, the value of securities in a margin account minus what has been borrowed from the brokerage.

4. In the context of real estate, the difference between the current fair market value of the property and the amount the owner still owes on the mortgage. It is the amount that the owner would receive after selling a property and paying off the mortgage. Also referred to as “real property value.”

5. In terms of investment strategies, equities are one of the principal asset classes. The other two are fixed-income (bonds) and cash/cash-equivalents. These are used in asset allocation planning to structure a desired risk and return profile for an investor's portfolio.

6. When a business goes bankrupt and has to liquidate, the amount of money remaining (if any) after the business repays its creditors. This is most often called “ownership equity” but is also referred to as risk capital or “liable capital.”

Calculating Equity

One could determine the equity of a business by determining its value (factoring in any owned land, buildings, capital goods, inventory and earnings) and deducting liabilities (including debts and overhead).

For example, suppose that Jeff owns and operates a factory that manufactures car parts and that he wants to determine the equity of his business. He estimates that the value of the property itself is $4 million, the total value of his factory equipment is $2 million, the current value of his inventory and supplies (processed and unprocessed) is $1 million and the value of his accounts receivable is $1 million. He also knows that he owes $1 million for loans he took out to finance the factory, that he owes his workers $500,000 in wages and that he owes his parts supplier $500,000 for goods he has already received. To calculate his business’s equity, Jeff would subtract his total liabilities from the total value of his business in the following way:

Total value – total liability = ($4M + $2M + $1M + $1M) - ($1M + $0.5M + $0.5M) = $8M - $2M = $6 million.

Jeff’s manufacturing company, then, is worth $6 million. It is also possible for equity to be negative, which occurs when the value of an asset is less than the value of liabilities on that asset. A company’s equity may often change, and for a variety of reasons. Causes of change in equity include a shift in the value of assets relative to the value of liabilities, depreciation and share repurchasing.

Equity is important because it represents the real value of one’s stake in an investment. Investors who hold stock in a company are usually interested in their own personal equity in the company, represented by their shares. Yet, this kind of personal equity is a function of the total equity of the company itself, so a shareholder concerned for his or her own earnings will necessarily be concerned for the company itself. Owning stock in a company over time will ideally yield capital gains for the shareholder, and potentially dividends as well. It also often bestows upon the shareholder the right to vote in Board of Directors elections. All of these benefits further promote a shareholder’s ongoing interest in the company.

Stockholders' Equity

Stockholders’ equity is synonymous with shareholders' equity: It represents the equity stake currently held on the books by a firm's investors and shareholders. It is calculated either as a firm's total assets minus its total liabilities, or (less commonly) as share capital plus retained earnings minus treasury shares. The result is listed on their balance sheets, and is often referred to as the book value of a company.

Stockholders’ equity functions as equity capital for a firm, which uses it to buy assets. Stockholders' equity has two main sources. The first is from the money initially invested in a company, along with additional investments made later. A second source is retained earnings that the company is able to build over time through its businesses: These earnings, net income from operations and other business activities, are actually returns on total stockholders' equity that are reinvested back to the company (instead of being distributed as stock dividends, say). Retained earnings grow larger over time, as the company continues to reinvest a portion of its income. At some point, the amount of accumulated retained earnings often exceeds the amount of equity capital contributed by stockholders, and can eventually grow to be the main source of stockholders' equity. In fact, retained earnings tend to comprise the largest component of stockholders’ equity for companies that have been operating for many years.

Treasury shares or stock (not to be confused with U.S.Treasury bills) represent stock that the company has bought back from shareholders. Companies may do this from time to time when management is not able to deploy all the available equity capital in ways that can potentially deliver the best returns. Shares bought back by companies become treasury shares, and their dollar value is noted in an account called treasury stock, a contra account to the accounts of investor capital and retained earnings. Treasury shares can be reissued back to stockholders (for a price) when companies need to raise money.

Stockholders' equity is often seen as representing a company's net assets – its net value, so to speak, the amount that would be returned to shareholders if all the company's assets were liquidated and all its debts repaid. It is one of the most common financial metrics employed by analysts to determine the financial health of a company.

For example, PepsiCo Inc.'s total stockholders' equity has declined in the past two years, from $17.4 billion in 2014 to $11.1 billion in 2016, which – depending on the reasons – might give analysts concern for the soda and snack food giant's health. In the same period, arch-rival Coca-Cola Corporation's total shareholders' equity has fallen as well, from $30.3 billion to $23.01 billion. But the percentage drop isn't as great, because Coke's liabilities and accounts payable have (unlike Pepsi's) consistently decreased, suggesting Coke has a better handle on its debt.

Private Equity

In a sense, private equity is the opposite of shareholders' equity. It involves funding that is not noted on a public exchange. Private equity comes from funds and investors that directly invest in private companies, or that engage in leveraged buyouts (LBOs) of public companies.

Private investors can include institutions (pension funds, university endowments, insurance companies, etc.) or individuals (high net worth families, friends and relatives). Private equity also refers to mezzanine debt, private placement loans, distressed debt and funds of funds
 
Private equity comes into play at different points along a company's life cycle. Typically, a very young company with no revenue and no earnings can't afford to borrow, so capital must be obtained from friends and family, or individual "angel investors." Venture capitalists enter the picture when the company has finally created its product or service, and is ready to bring it to market. (Some of the largest, most successful corporations in the tech sector, like Dell Technologies and Apple Inc. – began as venture-funded operations.) Venture capitalists generally provide all equity financing, in return for a minority stake; sometimes a venture capitalist will take a seat on the board of directors for its portfolio companies, ensuring an active role in guiding the company along. Venture capitalists look to hit big early on, and exit investments within five to seven years.
 
An LBO is one of the most common types of private equity financing, and might occur as a company matures. In an LBO transaction, a company receives a loan from a private equity firm to fund the acquisition of a division or another company. The loan is usually secured by the cash flows or the assets of the company being acquired. Mezzanine debt is a private loan, usually provided by a commercial bank or a mezzanine venture capital firm. Mezzanine transactions often involve a mix of debt and equity in the form of a subordinated loan or warrants, common stock or preferred stock.
 
Unlike shareholders' equity, private equity is not a thing for the average individual. To participate in private equity or venture capital partnerships, an investor must be "accredited" (have a net worth of at least $1 million). For investors who are less well-off, there is the option of exchange-traded funds (ETFs) that focus on investing in private companies.

Equity Begins at Home

Home equity is roughly comparable to home ownership: The amount of equity one has in his or her residence represents how much of it he or she actually owns outright. Equity on a property or home stems from payments made against a mortgage (including a down payment) and from increases in the value of the property.

Home equity is often an individual’s greatest source of collateral, and thus can be used in financing for a home-equity loan (often called a “second mortgage”) or a home equity line of credit. Taking money out of a property, or borrowing money against it, is known as equity takeout.

Brand Equity

When attempting to determine the value of assets in calculating equity, particularly for larger corporations, it is important to note that these assets may include both tangible assets like property, as well as intangible assets, like the company’s reputation and brand identity. Through years of advertising and development of a customer base, a company’s brand itself can come to have an inherent value. This concept is often referred to as “brand equity,” which measures the value of a brand relative to a generic or store brand version of a product.

For example, many soft-drink lovers will reach for a Coca-Cola before buying a store brand cola, because they prefer, or are more familiar with, the flavor. If a two-liter bottle of store brand cola costs $1 and a two-liter bottle of Coca-Cola costs $2, then the Coke has a brand equity of $1.

There is also such a thing as negative brand equity, if people are willing to pay more for a generic or store product than for that of a particular company. Negative brand equity is rare, and generally only occurs because of bad publicity, such as in the event of a product recall or disaster.

The Bottom Line

Equity has several meanings that vary by their context. But in general, each meaning refers to ownership in an asset. The equity of an individual – let's call her Sally – can be seen in different examples.

  • She owns 100 shares of stock in ABC Corporation. That stock is her equity in, or ownership of, ABC.
  • She has a house, whose current market value is $175,000, with a $100,000 outstanding mortgage. So she has $75,000 worth of equity in her home.
  • She also owns a business – Sally’s Signs. Her balance sheet shows the amount she’s contributed to it, which is $25,000, and its retained earnings, which is another $25,000. That’s $50,000 of equity in her business.

Equity also applies to the value of securities in a margin account, minus what an investor borrowed from her broker. And equity is one of the three principal asset classes. But in most of its meanings, equity equals the value of an asset, business or property, minus its outstanding debts, liabilities and other obligations.