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Word of the Week 'Equity'

May 1, 2019

 
What Is Equity?

Equity is typically referred to as shareholder equity (also known as shareholders' equity) which 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.

Equity is found on a company's balance sheet and is one of the most common financial metrics employed by analysts to assess the financial health of a company. Shareholder equity can also represent the book value of a company.

There are various types of equity that extend beyond a corporation’s balance sheet. In this article, we’ll explore the different types of equity including how investors can calculate a corporation’s equity or net worth.

 

Equity
KEY TAKEAWAYS
  • There are various types of equity, but equity typically refers to shareholder equity, which 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.

  • We can think of equity as a degree of ownership in any asset after subtracting all debts associated with that asset.

  • Equity represents the shareholders’ stake in the company. The calculation of equity is a company's total assets minus its total liabilities. 

The Formula for Shareholder Equity Is

Shareholders'~equity = Total~Assets - Total~Liabilities Shareholders′ equity=Total Assets−Total Liabilities

 

How to Calculate Shareholder Equity

The balance sheet holds the basis of the accounting equation, which is as follows:

Assets = liabilities + shareholder~equity Assets=liabilities+shareholder equity

However, we want to find the value of equity, which can be done as follows:

  1. Locate the company's total assets on the balance sheet for the period.

  2. Locate total liabilities, which should be listed separately on the balance sheet.

  3. Subtract total assets from total liabilities to arrive at shareholder equity.

  4. Total assets will equal the sum of liabilities and total equity.

What Does Equity Tell You?

The accounting equation for the balance sheet as well as equity has applications beyond companies. We can think of equity as a degree of ownership in any asset after subtracting all debts associated with that asset.

Below are several types of equity:

  • A stock or any other security representing an ownership interest, which might be in a private company in which case it’s called 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 valueand 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,” but some call it risk capital or “liable capital.”

Shareholder Equity 

Equity is important because it represents the value of an investor’s stake in a security or company. 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. Owning stock in a company over time may yield capital gains or stock price appreciation as well as dividends for shareholders. Owning equity can also give shareholders the right to vote in any elections for the board of directors. These equity ownership benefits promote shareholders ongoing interest in the company.

Equity represents the shareholders’ stake in the company. As stated earlier, the calculation of equity is a company's total assets minus its total liabilities.

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. 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.

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.

 

The Uses of Equity Issuance

Equity is used as capital for a company, which could be to purchase assets and fund operations. Stockholder 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. The funds from the issuance of equity could also be used to pay off debt or acquire another company.

 

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 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.

 

Real World Example of Shareholder Equity

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 = $196,831 or $354,628, (total assets) - $157,797 (total liabilities). 

Private Equity 

Equity can be categorized as either the 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 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 shareholder equity stated on the balance sheet.

This distinction is important because in private markets no readily available market value is available. Private equity generally refers 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 to raise capital.

Unlike shareholder 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.

For example, let’s say Sally has a house with a mortgage on it. The house has a current market value of $175,000 and the mortgage owed totals $100,000. Sally has $75,000 worth of equity in her home or $175,000 (asset total) - $100,000 (liability total).

 

Brand Equity 

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 Coke 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 Coke costs $2, then the Coca-Cola 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 Difference Between Equity and 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 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.

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