What Is Equity?
Equity, typically referred to as shareholders' equity (or owners' equity for privately held companies), represents the amount of money that would be returned to a company’s shareholders if all of the assets were liquidated and all of the company's debt was paid off in the case of liquidation. In the case of acquisition, it is the value of company sale minus any liabilities owed by the company not transferred with the sale.
In addition, shareholder equity can represent the book value of a company. Equity can sometimes be offered as payment-in-kind. It also represents the pro-rata ownership of a company's shares.
Equity can be found on a company's balance sheet and is one of the most common pieces of data employed by analysts to assess the financial health of a company.
- Equity represents the value that would be returned to a company’s shareholders if all of the assets were liquidated and all of the company's debts were paid off.
- We can also think of equity as a degree of residual ownership in a firm or asset after subtracting all debts associated with that asset.
- Equity represents the shareholders’ stake in the company, identified on a company's balance sheet.
- The calculation of equity is a company's total assets minus its total liabilities, and is used in several key financial ratios such as ROE.
Formula and Calculation for Shareholder Equity
The following formula and calculation can be used to determine the equity of a firm, which is derived from the accounting equation:
Shareholders’ Equity=Total Assets−Total Liabilities
This information can be found on the balance sheet, where these four steps should be followed:
- Locate the company's total assets on the balance sheet for the period.
- Locate total liabilities, which should be listed separately on the balance sheet.
- Subtract total liabilities from total assets to arrive at shareholder equity.
- Note that total assets will equal the sum of liabilities and total equity.
Shareholder equity can also be expressed as a company's share capital and retained earnings less the value of treasury shares. This method, however, is less common. Though both methods yield the same figure, the use of total assets and total liabilities is more illustrative of a company's financial health.
Understanding Shareholder Equity
By comparing concrete numbers reflecting everything the company owns and everything it owes, the "assets-minus-liabilities" shareholder equity equation paints a clear picture of a company's finances, which can be easily interpreted by investors and analysts. Equity is used as capital raised by a company, which is then used to purchase assets, invest in projects, and fund operations. A firm typically can raise capital by issuing debt (in the form of a loan or via bonds) or equity (by selling stock). Investors typically seek out equity investments as it provides greater opportunity to share in the profits and growth of a firm.
Equity is important because it represents the value of an investor’s stake in a company, represented by their proportion of the company's shares. Owning stock in a company gives shareholders the potential for capital gains as well as dividends. Owning equity will also give shareholders the right to vote on corporate actions and in any elections for the board of directors. These equity ownership benefits promote shareholders' ongoing interest in the company.
Shareholder equity can be either negative or positive. If positive, the company has enough assets to cover its liabilities. If negative, the company's liabilities exceed its assets; if prolonged, this is considered balance sheet insolvency. Typically, investors view companies with negative shareholder equity as risky or unsafe investments. Shareholder equity alone is not a definitive indicator of a company's financial health; used in conjunction with other tools and metrics, the investor can accurately analyze the health of an organization.
Components of Shareholder Equity
Retained earnings are part of shareholder equity and are the percentage of net earnings that were not paid to shareholders as dividends. Think of retained earnings as savings since it represents a cumulative total of profits that have been saved and put aside or retained for future use. 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 can exceed the amount of equity capital contributed by stockholders. Retained earnings are usually 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 existing shareholders. Companies may do a repurchase 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 view 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.
Example of Shareholder Equity
Using a historical example, below is a portion of Exxon Mobil Corporation's (XOM) balance sheet as of September 30, 2018:
- Total assets were $354,628 (highlighted in green).
- Total liabilities were $157,797 (1st highlighted red area).
- Total equity was $196,831 (2nd highlighted red area).
The accounting equation whereby assets = liabilities + shareholder equity is calculated as follows:
Shareholder equity = $354,628, (total assets) - $157,797 (total liabilities) = $196,831
Other Forms of Equity
The concept of equity has applications beyond just evaluating companies. We can more generally think of equity as a degree of ownership in any asset after subtracting all debts associated with that asset.
Below are several common variations on equity:
- A stock or any other security representing an ownership interest in a company.
- 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.”
- 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,” also known as risk capital or “liable capital.”
When an investment is publicly traded, the market value of equity is readily available by looking at the company's share price and its market capitalization. For private entitles, the market mechanism does not exist and so other forms of valuation must be done to estimate value.
Private equity generally refers to such an evaluation of 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 assets, arriving at an estimate of book value. Privately held companies can then seek investors by selling off shares directly in private placements. These private equity investors can include institutions like pension funds, university endowments, and insurance companies, or accredited individuals.
Private equity is often sold to funds and investors that specialize in direct investments in private companies or that engage in leveraged buyouts (LBOs) of public companies. 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.
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 Google, Apple, Facebook, and Amazon—or what is referred to as BigTechs or GAFAM—all began with venture capital funding.
Venture capitalists (VCs) provide most private equity financing in return for an early 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.
A final type of private equity is a Private Investment in a Public Company (PIPE). A PIPE is 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, to raise capital.
Unlike shareholder equity, private equity is not accessible 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. Such endeavors might require the use of form 4, depending on their scale. For investors who have don't meet this marker, 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 the value contained in home ownership. The amount of equity one has in their residence represents how much of the home that they own outright by subtracting from it the mortgage debt owed. 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.
For example, let’s say Sam owns a home with a mortgage on it. The house has a current market value of $175,000 and the mortgage owed totals $100,000. Sam has $75,000 worth of equity in the home or $175,000 (asset total) - $100,000 (liability total).
When determining an asset's 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 Coke before buying a store-brand cola because they prefer the taste, or are more familiar with the flavor. If a 2-liter bottle of store-brand cola costs $1 and a 2-liter bottle of Coke costs $2, then the Coca-Cola has 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 a disaster.
Equity vs. Return on Equity
Return on equity (ROE) is a measure of financial performance calculated by dividing net income by shareholder equity. Because shareholder equity is equal to a company’s assets minus its debt, ROE could be thought of as the return on net assets. ROE is considered a measure of how effectively management is using a company’s assets to create profits.
Equity, as we have seen, has various meanings but usually represents ownership in an asset or a company such as stockholders owning equity in a company. ROE is a financial metric that measures how much profit is generated from a company’s shareholder equity.
Frequently Asked Questions
What exactly is equity?
Equity is an important concept in finance that has different specific meanings depending on the context. Perhaps the most common type of equity is “shareholders’ equity," which is calculated by taking a company’s total assets and subtracting its total liabilities.
Shareholders’ equity is, therefore, essentially the net worth of a corporation. If the company were to liquidate, shareholders’ equity is the amount of money that would theoretically be received by its shareholders.
What are some other terms used to describe equity?
Other terms that are sometimes used to describe this concept include shareholders’ equity, book value, and net asset value. Depending on the context, the precise meanings of these terms may differ, but generally speaking, they refer to the value of an investment that would be left over after paying off all of the liabilities associated with that investment. This term is also used in real estate investing to refer to the difference between a property’s fair market value and the outstanding value of its mortgage loan.
How is equity used by investors?
Equity is a very important concept for investors. For instance, in looking at a company, an investor might use shareholders’ equity as a benchmark for determining whether a particular purchase price is expensive. If that company has historically traded at a price to book value of 1.5, for instance, then an investor might think twice before paying more than that valuation unless they feel the company’s prospects have fundamentally improved. On the other hand, an investor might feel comfortable buying shares in a relatively weak business as long as the price they pay is sufficiently low relative to its equity.