Equity

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An important aspect of investing for entrepreneurs and investors, equity plays a key role in company formation and asset liquidation.

In this wiki, readers will learn all about equity: what it is, how it works, and what are the different types of equity. 

Equity in a nutshell

  • Shareholder’s equity refers to the value of the company’s stocks once all of its assets have been liquidated
  • Market value of equity is the public value of the entity’s shares on the stock market
  • Shareholder’s equity helps to determine the value of a company, the involvement from investors, and can be used to grow the business and take out loans
  • Outstanding shares are the stocks that have been sold to investors
  • Additional paid in capital refers to what has been paid for the shares on top of their market value
  • Retained earnings refer to the income not paid out to shareholders, and treasury stock is the accumulation of repurchases shares
  • Private, home, and brand equity all refer to types of equity that add value to companies or individuals
  • Return on equity measures a company’s ability to generate profit based on its equity 

What is equity? 

Equity is also referred to as shareholders’ equity if the company’s stocks are public, or owners’ equity for privately held companies (i.e. one or few shareholders). In the event of asset liquidation, equity refers to the amount of money that would be returned to shareholders. For this to happen, the company must also have paid off all outstanding debts.

Interested parties can usually find a company’s equity on the balance sheet, and is one of the most common tools with which to analyse a company’s financial health.  

Book value of equity

Book value is the remaining value of the company once all assets have been liquidated, and is what shareholders stand to receive. 

For example, a company whose total asset value of €50 million with €40 million in liabilities, would leave the book value at €10 million. 

Assets that would have to be liquidated include physical assets: 

  • Inventory
  • Property
  • Plant
  • Equipment

And financial assets: 

  • Cash
  • Short-term investments
  • Accounts receivable

Market value of equity

Market value refers to a company’s value according to the stock market. While book market value is an estimation of the value of assets, market value communicates the current stock market value of those assets, if the company were to liquidate its assets at that moment. Market value is also referred to as market capitalisation. 

For example, if a company is trading at €25 per share and has one million shares, its market value would be €25 million. When a financial reporter refers to a company’s value, they usually mean market value. 

While a company’s number of shares will remain the same, market value changes throughout the day, with fluctuations in the stock market. This means the market value of a company is in constant flux. 

How does shareholder equity work?

When a company’s shareholder equity is calculated, it gives potential investors the clearest picture of a company’s financial health. The ‘assets minus liabilities’ equation can be easily interpreted by both analysts and interested investors, as to the current state and worth of the company. 

For companies, equity is used as capital to fund projects, grow the business, and influence daily operations. Capital can be raised when a company issues debt via loans or equity by selling stock. When this is done, the company has cash to raise its value through other investments. 

Shareholder equity is also important for investors because it represents their stake in the company. The amount of shares an investor has usually measures their influence over the company. 

With shares and influence, investors can partake in the company’s future by:

  • Attending boardroom meetings
  • Vote on corporate decisions
  • Make decisions on future investments
  • Bring in other potential shareholders

Shareholder equity can be both negative and positive: 

  • Negative shareholder equity: company’s liabilities exceed its assets
  • Positive shareholder equity:  company’s assets exceed liabilities

Investors view companies with negative equity as more of a risk to invest in, because the company may never reach a point where its assets exceed its liabilities. However, shareholder equity is not the only measure of a company’s financial health and will not eliminate the possibility of any investment in the company.  

How to calculate equity

There are a few different equations which can be used to calculate a company’s equity in totality. 

Shareholder’s equity, which is also expressed as book value  is calculated like this:

Total assets – total liability = shareholder’s equity

The market value of a company depends on the value of its shares and is calculated like this:

Current market price per share x number of outstanding shares

Free download: equity calculation template

In case you need a bit of help to calculate your company’s own equity, you can just download our calculation template for free. Just add your individual numbers in the cells highlighted in green. The correct calculation results will then appear in the orange cells automatically.

Download template

What are the components of shareholder equity?

To further clarify the above equations, components of shareholder equity must be broken down. This makes assessing the value of total shares much more accurate.

Outstanding shares

Outstanding shares are the shares that have been sold by the company to investors and not repurchased by the company. They are outstanding because they are no longer in sole possession of the company owners. 

Outstanding shares can also be used to calculate market capitalisation and earnings per share. 

Additional paid-in capital

This represents the amount paid for the shares at face value (commonly referred to as ‘par value’). Additional paid-in capital or APIC is derived from the difference between the value of the stock and what has been paid for it. 

APIC occurs when an investor buys stock directly from the company and represents the additional amount paid by the investor, on top of its par value. 

Retained earnings

Created when a company retains income instead of paying it out to stockholders, retained earnings can create a positive balance in the company’s account. The company may then use them to pay off debts or reinvest in the business. 

Retained earnings will often be the largest line item in the company’s balance sheet and may be referred to as ‘retention ratio’ or ‘retained surplus’. 

Treasury stock 

The final component in shareholder’s equity, treasury stock, refers to the number of shares sold to investors which have then been repurchased by the company. Treasury stock can be used to raise capital or prevent a hostile takeover, in which the company is forcefully acquired by another.

Calculating equity, treasury stock will be subtracted from the company’s total equity, because this presents a more accurate reading of available shares for investors.  

Which other types of equity are there?

Certain types of equity determine the value of a certain asset or investment from a company or individual. Below are definitions of the three major types of equity.

Private equity

Private equity is not listed on a public exchange. It comprises capital not listed on a public exchange, therefore it is not accessible to the public. Made up of funds and investors directly investing in companies or engaging in company buyouts, private equity can be used to fund equipment or new technologies, fund acquisitions, or simply improve a balance sheet.

Private equity funds include Limited Partners (LP) who own 99% of the private equity shares, and General Partners, who own the remaining 1%. 

Home equity

 A form of home ownership, home equity is essentially how much of a residence that an individual owns. It is determined by subtracting from the mortgage debt owed, because equity is accumulated with each payment made on the residence’s mortgage. The bigger the payments made, the larger the home equity., i.e. the more ownership the individual has over the home. 

Home equity is a source of collateral for homeowners, because the market value of the house outside its total mortgage can be used to sell the house for more than the mortgage, thus making a profit on the home. 

Brand equity

An intangible asset of a person or company, brand equity differs from the value of its physical assets, i.e. property, resources, or staff. Brand equity measures the value of the company’s name and reputation, especially when compared with competing generic brands.

This is usually the reason consumers pay more for so-called ‘name brand’ products than they do for generic ones, because they are paying for the quality the brand represents. In modern marketing, celebrities often leverage their brand equity when seeking advertisers on a podcast: advertisers will pay more to be advertised on the show of a well-known celebrity because it promises more return on investment. 

The difference between equity and return on equity

Where equity determines the value of shares after a company has liquidated its assets, Return on Equity or ROE is a measure of a company’s profitability and efficiency in generating profits. It measures how effective the company is at generating profits based on its equity. 

Return on equity can be calculated if the company’s net income and liabilities are represented positively. The equation is: 

Net income / Average shareholder’s equity = Return on equity]

Investors will usually look to invest in a company whose ROE is close to the average ROE in that company’s industry. If the industry average ROE is 15%, and Company X has steadily maintained an 18% ROE, then the investor can assume Company X has maintained above average management and profits over a long period of time.  

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