What is Equity
When studying financial statements, an important concept is the balance sheet identity. It states that assets minus liabilities equals stockholders’ equity. Theoretically, stockholders’ equity (also known as shareholders’ equity, or book value), is the value left over for shareholders if a company (or any entity) would utilize its assets to meet its liability obligations. The rest is equity.
The accounting equation is: Assets - Liabilities = Equity.
This accounting equation has applications beyond companies. One can think of equity as one’s degree of ownership in any asset after subtracting all debts associated with that asset. Any loan that requires a down payment, there is an asset, liability, and equity. For example, a car or house with no debt contains a component of owner's equity.
BREAKING DOWN Equity
The following are more specific definitions for the various forms of equity:
- A stock or any other security representing an ownership interest. This may be in a private company, in which case it is a private equity.
- On a company's balance sheet, the amount of the funds contributed by the owners or shareholders plus the retained earnings (or losses). One may also call this stockholders' equity or shareholders' equity.
- In margin trading, the value of securities in a margin account minus what the account holder borrowed from the brokerage.
- In real estate, the difference between the property's current fair market value 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 any liens. Also referred to as “real property value.”
- In investment strategies, equities are one of the principal asset classes. The other two classes 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.
- When a business goes bankrupt and has to liquidate, equity is the amount of money remaining after the business repays its creditors. This is most often called “ownership equity,” but some call it risk capital or “liable capital.”
We mentioned above that the accounting identity is usually theoretical for public companies. In the vast majority of cases they operate as going concerns and are thus unlikely to liquidate. However, one can determine a any entity’s equity by making estimates about the asset’s market value. The value stated on a balance sheet might be outdated or subject to accounting conventions that stipulate historical, or original cost. Assets that would need to be valued can include land, buildings, property plant & equipment (PP&E), capital goods, inventory and earnings, and deducting liabilities like debts and overhead.
For example, suppose Jeff owns and operates a car-parts factory and wants to determine the equity of his business. He estimates 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 is $1 million, and the value of his accounts receivable is $1 million. He also owes $1 million in loans he took out to finance the factory, $500,000 in wages and $500,000 to a parts supplier for goods previously received. To calculate his 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 is worth $6 million in this example. It is also possible to have negative equity, which occurs when an asset's value is less than its liabilities. A company’s equity may often change for a variety of reasons. Causes of change in equity include a shift in an asset 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 personal equity in the company, represented by their shares. Yet, this kind of personal equity is a function of the company's total equity, so a shareholder concerned for his or her own earnings will also have a concern for the company. Owning stock in a company over time will ideally yield capital gains for the shareholder and potentially dividends. It can also give the shareholder the right to vote in board of directors elections. These benefits further promote a shareholder’s ongoing interest in the company.
As detailed earlier, stockholders’ equity is synonymous with shareholders' equity, or book value: It represents the equity stake held on the books by a firm's shareholders. Its calculation is a firm's total assets minus its total liabilities or as share capital plus retained earnings minus treasury shares. This is also known as the book value of a company.
Equity first functions as equity capital for a firm, which it uses to buy assets and start operations. Stockholders' equity has two main sources. The first is from the money initially invested in a company and additional investments made later. In the public markets, the first time a company issues shares on the primary market, this equity is used to either start operations, or in the case of an established company, for growth capital. For established companies, this can be a liquidity event letting certain shareholders establish a market value for their equity (the publicly traded stock).
A second source is retained earnings that the company can build over time through its businesses: These earnings, net income from operations and other business activities, are returns on total stockholders' equity that the company reinvests into itself instead of distributing them as stock dividends. 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 are the largest component of stockholders’ equity for companies that have been operating for many years. Warren Buffett’s Berkshire Hathaway has retained earnings for many decades and touts its track record in growing book value to boost shareholder value for its stock holders.
Treasury shares or stock (not to be confused with U.S.Treasury bills) represent stock that the company has bought back from existing shareholders. Companies may do this when management cannot deploy all the available equity capital in ways that might 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. Companies can reissue treasury shares back to stockholders when companies need to raise money.
Many see stockholders' equity as representing a company's net assets – its net value, so to speak, would be the amount shareholders would receive if the company liquidated all its assets and repaid all its debts. It is one of the most common financial metrics analysts use to determine a company's financial health.
For example, PepsiCo Inc.'s total stockholders' equity declined in the 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 fell from $30.3 billion to $23.01 billion. But the percentage drop isn't as great because Coke's liabilities and accounts payable have consistently decreased, while Pepsi's have increased, suggesting Coke has a better handle on its debt.
Equity can be categorized as either market value of equity or book value. When an investment is publicly traded, market value is readily available. Interested parties can also have a valuation done to estimate a market value. A homeowner wishing to sell a home will hire a realtor to establish a comparable market value with which to establish an estimated sales price (and the owner’s equity will represent its assets (percent of home owned) minus liabilities (the outstanding mortgage). Book value is shareholders’ equity stated on the balance sheet.
This distinction is important, because in private markets no readily available market value is available. Private equity refers generally to companies that are not publicly traded. The accounting equation still applies where stated equity on the balance sheet is what is left over when subtracting liabilities from 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, including pension funds, university endowments and insurance companies, or individuals. 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 young company with no revenue or earnings can't afford to borrow, so it must get capital 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 provide most 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. 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. Cash flows or the assets of the company being acquired usually secure the loan. 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.
A final type of private equity is a Private Investment in a Public Company, or PIPE. A PIPE is s a private investment firm's, a mutual fund's or another qualified investors' purchase of stock in a company at a discount to the current market value (CMV) per share for the purpose of raising capital.
Unlike shareholders' equity, private equity is not a thing for the average individual. Only "accredited" investors, those with a net worth of at least $1 million, can take part in private equity or venture capital partnerships. 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 the home he or she owns outright. Equity on a property or home stems from payments made against a mortgage, including a down payment, and from increases in property value.
Home equity is often an individual’s greatest source of collateral, and the owner can use it to get a home-equity loan, which some call a second mortgage or a home-equity line of credit. Taking money out of a property or borrowing money against it is an equity takeout.
When determining an asset's in calculating equity, particularly for larger corporations, it is important to note these assets may include both tangible assets, like property, and intangible assets, like the company’s reputation and brand identity. Through years of advertising and development of a customer base, a company’s brand can come to have an inherent value. Some call this value “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 2-liter bottle of store-brand cola costs $1 and a 2-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, which is when people will pay more for a generic or store-brand product than they will for a particular brand name. Negative brand equity is rare, and can occur because of bad publicity, such as a product recall or disaster.
The Bottom Line
Equity has many meanings that vary depending on the context it is used. But each meaning refers to ownership in an asset after all related obligations have been satisfied. 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. This type of equity is commonly purchased through brokerages. You can check out some of the best in the industry with Investopedia's list of the best online brokers.
- She has a house with a current market value of $175,000 and a $100,000 mortgage. She has $75,000 worth of equity in her home.
- She also owns a business, Sally’s Signs. Her balance sheet shows she’s contributed $25,000 to it and it has $25,000 in retained earnings. That’s $50,000 of equity in her business.
In most of its meanings, equity equals the value of an asset, business or property, minus its outstanding debts, liabilities and other obligations.