Equity Definition: What it is, How It Works and How to Calculate It (2024)

What Is Equity?

Equity, typically referred to asshareholders' 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 sales 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 a company's financial health.

Key Takeaways

  • 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 it's used in several key financial ratios such as ROE.
  • Home equity is the value of a homeowner's property (net of debt) and is another way the term equity is used.

Equity Definition: What it is, How It Works and How to Calculate It (1)

How Shareholder Equity Works

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, 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 usually seek out equity investments as it provides a 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 the proportion of its shares. Owning stock in a company gives shareholders the potential for capital gains and dividends. Owning equity will also give shareholders the right to vote on corporate actions and 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.

Formula and How to Calculate Shareholders' 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=TotalAssetsTotalLiabilities\text{Shareholders' Equity} = \text{Total Assets} - \text{Total Liabilities}Shareholders’Equity=TotalAssetsTotalLiabilities

This information can be found on the balance sheet, where these four steps should be followed:

  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 liabilities from total assets to arrive at shareholder equity.
  4. 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 exact figure, the use of total assets and total liabilities is more illustrative of a company's financial health.

What the Components of Shareholder Equity Are

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 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 of the available equity capital in ways that might deliver the best returns. Shares bought back by companies become treasury shares, and the 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 of its assets and repaid all of 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.
  • Total liabilities were $157,797.
  • Total equity was $196,831.

The accounting equation whereby Assets = Liabilities + Shareholder Equity is calculated as follows:

Shareholder Equity = $354,628, (Total Assets) - $157,797 (Total Liabilities) = $196,831

Equity Definition: What it is, How It Works and How to Calculate It (2)

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 funds contributed by the owners or shareholders plus the retained earnings (or losses). One may also call thisstockholders' equity or shareholders' equity.
  • The value of securities in a margin account minus what the account holder borrowed from the brokerage in margin trading.
  • 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 often called "ownership equity," also known asrisk capital or "liable capital."

Private Equity

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 entities, the market mechanism does not exist, so other valuation forms 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, 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 of 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 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, Amazon, and Meta—or what is referred to as GAFAM—began with venture capital funding.

Types of Private Equity Financing

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 to 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 form 4, depending on their scale. For investors who don't meet this marker, there is the option of private equity exchange-traded funds (ETFs).

Home Equity

Home equity is roughly comparable to the value contained in homeownership. The amount of equity one has in their residence represents how much of the home they own outright by subtracting from the mortgage debt owed. Equity on a property or home stems from payments made against a mortgage, including a down payment and 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 mortgageor a home equity line of credit (HELOC). An equity takeout is taking money out of a property or borrowing money against it.

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).

Brand Equity

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 the 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 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 considered the return on net assets. ROE is considered a measure of how effectively management uses 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.

What Is Equity in Finance?

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.

How Is Equity Calculated?

Equity is equal to total assets minus its total liabilities. These figures can all be found on a company's balance sheet for a company. For a homeowner, equity would be the value of the home less any outstanding mortgage debt or liens.

Equity Definition: What it is, How It Works and How to Calculate It (2024)

FAQs

Equity Definition: What it is, How It Works and How to Calculate It? ›

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 it's used in several key financial ratios such as ROE.

What is equity and how is it calculated? ›

Total equity is the value left in the company after subtracting total liabilities from total assets. The formula to calculate total equity is Equity = Assets - Liabilities. If the resulting number is negative, there is no equity and the company is in the red.

What is a simple way to explain equity? ›

The term “equity” refers to fairness and justice and is distinguished from equality: Whereas equality means providing the same to all, equity means recognizing that we do not all start from the same place and must acknowledge and make adjustments to imbalances.

How do you calculate own equity? ›

It is calculated by deducting all liabilities from the total value of an asset (Equity = Assets – Liabilities).

How do you calculate equity value? ›

Market value of equity is the same as market capitalization and both are calculated by multiplying the total shares outstanding by the current price per share. Market value of equity changes throughout the trading day as the stock price fluctuates.

Why do we calculate equity? ›

The most common use of equity value is to calculate the Price Earnings Ratio. While this multiple is the most well known to the general public, it is not the favorite of bankers.

What is an example of equity? ›

Equity is providing a taller ladder on one side or propping the tree up so it's at an angle where access is equal for both people. A line of people of different heights are watching an event from behind a fence. Equality is giving equal opportunity for each person to get a box to stand on to get a better view.

What is equity in one sentence? ›

The company is considering raising part of its future capital requirements by selling equity to the public. Equity is the sum of the assets or investments of a business after liabilities have been subtracted.

How does equity make money? ›

Equity investors purchase shares of a company with the expectation that they'll rise in value in the form of capital gains, and/or generate capital dividends.

How do you explain equity to a child? ›

Equity refers to the principle of fairness. Equity is similar to equality, but equality only works when everyone starts at the same place. Therefore, equity focuses on helping people obtain what they need so they can get to a place where equality is possible.

What does it mean when a company gives you equity? ›

Equity compensation also known as share-based or stock-based compensation, is a type of non-cash pay that a company offers to employees to partake in ownership of the firm, whether it's a private or public company.

What is owner's equity in simple words? ›

Owner's equity is essentially the owner's rights to the assets of the business. It's what's left over for the owner after you've subtracted all the liabilities from the assets. If you look at your company's balance sheet, it follows a basic accounting equation: Assets – Liabilities = Owner's Equity.

What falls under owner's equity? ›

Owner's equity (also referred to as net worth, equity, or net assets) is the amount of ownership you have in your business after subtracting your liabilities from your assets. This shows you how much capital your business has available for activities like investing.

How much equity can I borrow from my home? ›

It depends on how much equity you have and your lender. Regardless, though, you can't take out the full amount of equity — so if you have $100,000 in equity, say, you can't simply access $100,000. Most lenders allow you to borrow 80 percent to 85 percent of your home's appraised value.

What is an example of a home equity? ›

Home equity is the value of your house minus the amount you owe on your mortgage or home loan. When you first buy a house, your home equity is the same as your down payment. If you buy a house for $250,000 with a down payment of $25,000, you begin with $25,000 in home equity.

What does 5% equity mean? ›

And remember, equity is expensive. Giving someone a 5% stake, means that that party owns 5% of your firm's net worth and profits forever!

What does 20% equity mean? ›

Let us pretend that you purchased a home for $200,000. When you made the purchase, you put down 20 percent as your down payment. In order to pay for the rest, you got a loan from a mortgage lender. This means that from the start of your purchase, you have 20 percent equity in the home's value.

Is equity your own money? ›

Your equity is the share of your home that you own versus what you owe on your mortgage. For example, if your home is worth $300,000 and you have a mortgage balance of $150,000, then you have equity of $150,000, or 50 percent.

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