If you’re serious about investing then you need to know about equity. Equity is a powerful tool that investors and investment firms rely on to decide which investments to make and which to avoid. Knowing what equity is and why it matters can help you make better investments and strengthen your investment portfolio.
Equity is a term used widely by financial professionals in different capacities. Put simply, equity means ownership. Whether you’re a shareholder or property holder, equity represents the amount of money that is yours if you had all assets liquidated and debt paid off.
Another way to think about equity is that equity is your assets’ net worth. Equity is generally referred to as shareholder equity, which is calculated as total assets minus its total liabilities.
Shareholder Equity = Total Assets − Total Liabilities
How Does Equity Work?
While equity can seem like an abstract concept, it is part of everyday life. Investors, loan holders, homeowners, individuals and businesses all rely on equity to some extent to purchase assets, start operations and capital growth. Equity funds can also be used to pay off debt.
Shareholder equity typically comes from two main sources:
- Initial investments: Ground-level investments that provide enough capital for a company to start up and go public
- Additional investments: Investments made after a company has gone public and is expanding or acquiring new assets
Equity can represent the current cash value of an asset or its potential value. Equity alone is not a definitive indicator of health, but when used in combination with other metrics it is a valuable tool for analyzing the health of a company or financial situation.
Why Does Equity Matter?
Equity functions as capital for a company and can be either positive or negative. A company with positive shareholder equity has enough assets to cover its liabilities. In non-technical language, if push came to shove, a company with positive equity could cash in everything to pay off its debts. Shareholders’ stakes have value.
Negative equity means that a company’s liabilities are greater than its assets. If you were talking about banking, that would mean you didn’t have enough cash in the bank to pay off your debts. Equity doesn’t work like that. Negative equity doesn’t mean that stakeholders are in debt. Instead, negative equity reflects the amount of assets that a company would have to generate before investors could see returns. Consequently, the value of stakeholders’ stakes is 0 until that amount is generated.
Why is this important? Because investors and investment firms typically view companies with negative equity as risky investments and tend to avoid them.
Types of Equity
There are five types of shareholder equity representing various ways that investors can own shares or invest in ownership of a company.
Common stock equity, also called common shares, represents stakeholder ownership of a company. Common stock investors receive income via capital gains or dividends that are paid per share. Common stock value is determined by multiplying the stock value with the total number of shares.
For example, 100,000 shares valued at $1 would result in $100,000 of common stock value.
Common stock stakeholders have the right to vote and have access to certain company assets. As a result, common stock investors have significant influence on the company’s affairs and earn greater capital gains than preferred shareholders.
Preferred share ownership is similar to common stock but shareholders have limited involvement. Preferred share investors have no voting rights or responsibilities within a company and are only involved with a company at a financial level. Each year preferred shareowners are guaranteed a cumulative dividend. A cumulative dividend means that if a dividend is not paid off in 1 year, it will accumulate until it is paid.
For example, a preferred share investor is entitled to $10 of cumulative dividends per year. If the company does not pay dividends for 2 years but is able to in the 3rd year, then a preferred shareholder will receive $30 total in cumulative dividends at the end of the 3rd year ($10 per year x 3 years = $30).
Sometimes a company buys back stock from common stockholders. This amount is deducted from the total equity of a business and is called treasury stock. While treasury stock itself doesn’t hold much value, companies often use treasury stock to boost share prices or offer share incentives for employees.
For example, if a company’s initial shareholder equity is valued at $3 million but it buys back $1 million from common stockholders as treasury stock, the result is $2 million in stakeholder equity ($3 million initial stakeholder equity – $ 1 million treasury stock = $2 million stakeholder equity).
Contributed surplus is an amount that is paid over the par value of a stock. Par value is what the stock is actually worth whereas market value is what investors are willing to pay for it. Contributed surplus can also be referred to as additional paid-in capital and is entered onto a company's balance sheet as the amount raised above par value.
For example, a company issues 10,000 shares with $1 par value shares at $5 per share. $10,000 ($10,000 shares x $1/par value share = $10,000) would go to common stock and the remaining $40,000 (10,000 shares x $4 amount over par value = $40,000) would go to contributed surplus.
The amount of contributed surplus can change based on a company’s gains or losses and be used to fund various business operations or investments.
Retained earnings is company income that is not paid to stockholders via dividends. Companies can use the leftover money to invest in additional assets, reinvest in the company or save for future needs.
For example, say a company earned $10 million. It needed $8 million to meet all of its financial obligations, including paying stockholders. That would leave a surplus or retained earnings amount of $2 million.
The Next Best Thing
Equity might not be money in the bank but it is the next best thing. Businesses and individuals rely on equity to inform financial decisions, particularly when it comes to investing. Equity can indicate financial ownership of an asset, the potential value of an asset or the overall health of a company.
Be careful not to base investment decisions solely on equity, however. Rather, examine equity along with other indicators to help you develop a clear picture of the company you’re investing in.
Frequently Asked Questions
What is equity in investing?
Equity in investing is money that the investor put in a company to purchase shares of it in the stock market.
What is the difference between a stock and equity?
Stocks grant an ownership in a company, so all stocks are a form of equity.
Why are shares called equity?
Shares are called equity because they are the same as stocks and stocks are equity in a company.