DEFINITION: The term “equity” refers to the total amount of money that would be distributed to a given shareholder if he were to liquidate all his shares.
The term may also be used in a collective sense, in which case it is also known as “shareholder equity” (in the case of publicly traded companies) or “owners’ equity” (in the case of privately held companies).
In the collective sense, equity refers to the total amount of money that would be distributed to all shareholders as a group if all the company’s assets were liquidated and the value of all its outstanding shares paid out.
ETYMOLOGY: The English term “equity” is attested from the fourteenth century. It derives from Middle English equite, Middle French équité, and, ultimately, from the Latin noun aequitas, aequitatis, meaning “evenness,” “impartiality,” “fairness,” “justice.” The noun, in turn, is derived from the Latin adjective aequus, meaning “even” or “equal.”
USAGE: When a company is acquired, its equity in the collective or “shareholder equity” sense is determined by deducting any liabilities from the total value of the sale (assets).
shareholder equity = total assets – liabilities
Moreover, shareholder equity can serve as the “book value” of a company. It can even be used, on occasion, as payment-in-kind.
Listed on a company’s balance sheet, equity is a vital piece of information often used by analysts to evaluate a company’s financial health.
The “assets-minus-liabilities” shareholder equity formula makes it possible to make an objective assessment of a company’s finances by considering precise figures representing its assets and liabilities.
Shareholder equity is readily understood by investors and analysts. It may function as the capital raised by a company that is then used to support operations, acquire assets, and invest in new projects.
Companies may raise capital by means of either debt (loans or bonds) or equity (selling stocks). Investors frequently prefer the latter, seeing that owning stock shares offers a greater chance of participation in a company’s growth and profits.
Possessing company stock also provides shareholders with the opportunity for receiving dividends and earning capital gains. Moreover, equity ownership (in the individual sense) grants shareholders the right to vote on corporate matters, including in elections of boards of directors. In these ways, equity ownership stimulates shareholders’ continuing interest in the company.
Shareholder equity in the collective sense can be either positive or negative. Having positive equity indicates that a company’s assets are greater than its liabilities. Having negative equity means that the company’s liabilities are greater than its assets.
The appearance of negative equity on a company’s balance sheet, which persists over some time, may indicate that the company is insolvent.
Companies with negative shareholder equity are often perceived to be risky investments. However, by itself shareholder equity is not a conclusive metric of a firm’s financial well-being. Rather, equity must be combined with other factors to portray accurately a company’s overall financial health.
Components of Shareholder Equity
Retained earnings: Retained earnings make up a portion of shareholder equity, which represents any net earnings that are not distributed as dividends. Thus, companies’ retained earnings are similar to individuals’ savings, inasmuch as they accumulate over time, forming a fund set aside for future use. Retained earnings increase as the company reinvests a portion of its income.
Over time, the accumulated retained earnings might surpass the equity capital contributed by stockholders. For companies with a long operational history, retained earnings often become the largest component of stockholders’ equity.
Treasury shares: The phrase “treasury shares,” also known as “treasury stock” (nothing to do with US Treasury bills), refers to the company’s own stock that has been repurchased from existing shareholders.
Companies may decide to repurchase shares when it is difficult for them to make optimal use of all available equity capital. These repurchased shares are called treasury shares, whose dollar value is recorded in a separate treasury stock account. If there is a need to raise capital in the future, companies may reissue treasury shares to stockholders.
Other Kinds of Equity
The notion of equity is also applicable in contexts beyond the evaluation of companies’ balance sheets.
In a broad sense, equity is simply the proportion of ownership of an individual or company in any asset considered as a fraction of the total amount of debt associated with that asset.
Among several different kinds of equity, we may mention the following:
- In the context of margin trading, the term “equity” refers to the value of securities in a margin account minus the amount borrowed from the brokerage.
- In the context of real estate, “equity” signifies the difference between the property’s current fair market value and the amount the homeowner still owes the bank, i.e., the outstanding mortgage amount.
- In the context of a company’s bankruptcy and liquidation, equity is the amount remaining after all its creditors have been repaid. This is often called “risk capital,” “liable capital,” or “ownership equity.”
Public vs. Private Equity
If a company’s stock is publicly traded, determining the market value of its shareholder equity is straightforward, obtainable by finding the company’s share price and market capitalization.
For private companies—that is, ones whose stock is not publicly traded—the market mechanism is absent. For this reason, alternative valuation methods must be used to estimate their value.
Privately held companies may attract investors by directly selling shares through private placements. These private equity investors may include accredited individuals and institutions such as pension funds, insurance companies, and university endowments.
Private equity plays a role at various stages of a company’s existence. Generally speaking, a start-up company without revenue or earnings will not be able to secure loans, so it often relies on capital from friends, family, or individuals known as “angel investors.”
Later on, venture capitalists become involved when the company has developed its product or service and is prepared to bring it to market. At this stage, private equity is frequently offered to funds and investors specializing in direct investments in private companies or engaging in leveraged buyouts (LBOs) of public companies.