Authors: Matt Ryan Webber
Source: Money
Equity
Definition
Equity is commonly used in several different circumstances - home equity, shareholder equity, and brand equity. In general, it is the value of the assets held by a company or individual, minus the debt that is associated with them.
Equity explained
Equity is the value of an investor’s ownership of an asset. The concept of equity is most commonly applied to two types of assets: a shareholder’s equity in a company, or a homeowner’s equity in their property. Less commonly, the term equity is also applied to intangible assets, such as the brand equity of a company.
Equity is calculated by taking the total value of assets and subtracting the debt associated with them.
For example, a homeowner’s equity in their property is the total value of their property (how much they can expect to sell their house for), minus the outstanding debt on this asset (how much of the mortgage they still owe to their lender).
A similar concept is also applied to companies. If a company holds $1 million in assets, but has $500,000 in debt, the total equity of the firm is $500,000. Each shareholder in the firm technically owns a portion of this equity corresponding to how many shares they hold.
In investing, a company’s equity can be found on a company’s balance sheet, which details the assets a company owns and the value of its outstanding debts. This type of equity is a key piece of information that is used to assess the financial health of a company.
How shareholder equity works
In principle, a shareholder’s equity is the amount of money that would be returned to them if a company liquidated all of its assets and paid off all its debts. Balancing assets and debt is a key concern for many companies. A firm typically can raise capital by issuing debt (in the form of a loan or via bonds) or equity (by selling stock).
Shareholder equity is an important and relatively straightforward measure of a company’s financial health. A company that owns many valuable assets may appear to be a good investment opportunity. However, if the same company also has significant debts, it may be less robust than it at first appears.
Shareholder equity is important for investors for at least two reasons. The first is that owning equity in a firm gives shareholders the potential for capital gains and dividends: that is, a return on their investment. Secondly, owning equity often affords shareholders the right to vote on corporate actions and in elections to the board of directors. This gives them a say in the way that a company is run.
Shareholder equity can be positive or negative. If the value of the total assets held by a company is greater than its outstanding debts, shareholder equity is positive. If its debts are greater than the value of its assets, shareholder equity is negative. A company with negative equity is commonly regarded as a risky investment, and if a company has negative equity for a long time it may be considered “balance sheet insolvent” because it won’t be able to pay investors back if it failed.
Equity vs. return on equity (ROE)
Return on equity (ROE) is a concept that is derived from shareholder equity. ROE is calculated by taking the income of a company and dividing this by shareholder equity. ROE is often used as a measure of financial performance by investors because it can be considered a measure of the return on investment in a company.
More precisely, the ROE of a given company indicates how efficient it is in generating profits from assets.
How to calculate shareholder equity
Calculating shareholders’ equity in a company is relatively straightforward because it only takes into account two key figures that appear on a firm’s annual balance sheet. These are a company’s total assets and its total liabilities.
Shareholders’ equity can then be calculated using this formula:
Shareholders’ Equity = Total Assets – Total Liabilities
Example of shareholder equity
For example, if a company’s balance sheet indicates that it holds $1 million in assets and has $500,000 of outstanding debt, the total shareholders’ equity is $500,000.
Individual shareholders can then use this figure to calculate how much their portion of the ownership of the company is worth. If a shareholder owned 10% of the same company, for example, then their equity in the firm would be worth $50,000.
This is a simple example. In practice, calculating the value of a stake in a company can be more complex for a number of reasons:
- Some companies issue a variety of different types of shares, and some shares do not represent direct ownership of a company.
- Some shares pay dividends directly to shareholders, and these can be valuable even if a shareholder doesn’t own a company directly.
- More generally, companies rarely go through total liquidation while in a positive equity position, and so it’s rare that a shareholder is ever paid the total value of their equity.
Other types of equity
The concept of equity is commonly applied in a number of other situations. The concept is similar in each — equity is the value of assets minus debt obligations. However, each type of equity works in slightly different ways.
Private equity
If shares in a company are publicly traded – that is, listed on a stock exchange – it is relatively easy to calculate shareholders’ equity, because companies are required to report the value of their assets and debt annually. However, some companies are not publicly traded, or only a portion of a company is, but they still have shareholders. These companies are known as private equity firms, and the equity they hold is known as private equity.
Privately held companies can still sell shares, but they don’t do so on the open market. Instead, they 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 can be very important for new businesses. A young company that is not generating revenue and holds no assets may find it difficult to borrow capital from a bank. Instead, they will seek private “angel investors” who are willing to invest in the company at this early stage in exchange for private equity.
It’s uncommon for the average investor to have access to private equity. Only “accredited investors” with a high net worth can generally invest in this way. However, in recent years we’ve seen the development of private equity exchange-traded funds (ETFs), which allow smaller-scale investors to gain some exposure to the private equity market.
Home equity
Another type of equity is home equity. Homeowners are familiar with this type because it represents the value of the portion of their home that they own.
Just as with shareholders’ equity, home equity is calculated by taking the total value of an asset (in this case, real estate), and subtracting the value of outstanding debts that are associated with it (commonly, a mortgage). In order to calculate home equity, you take the fair market value of your home — that is, the amount of money you would expect to sell it for — and subtract the total value of your outstanding mortgage payments.
When calculating equity, it’s important to differentiate this from the amount you’ve so far paid for your home. While your payments form part of your equity, so does home’s appreciation, the potential increase in price due to demand, inflation, and other factors.
Home equity is important for homeowners for at least two reasons. One is that it represents the portion of their home that they own. Another is that owning a significant amount of equity in your home can allow you to access specialized forms of credit. 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 (HELOC).
Brand equity
The concept of equity can also be applied to assets that are intangible. This is a more recent use of the term and can be more complex to calculate than shareholder or home equity.
The central idea of brand equity is that by building up brand recognition or a loyal customer base, a company’s brand can have value in itself. This is only loosely related to the tangible assets that a company owns.
For example, Coca-Cola is an internationally recognized brand, and has many loyal customers. A can of Coke, however, may cost more than a comparable can of generic cola. If a bottle of Coca-Cola costs $2, and a comparable generic cola sells for $1, Coca-Cola is said to have $1 of “brand equity.” This can then be scaled according to the value of the cola market.
It can be difficult to asses a company’s brand equity because this relies on a subjective assessment of the power of a company’s brand in driving purchasing decisions. However, brand recognition, and therefore brand equity, can be important factors for investors to consider.
Equity key takeaways
- The term equity is commonly used in several different circumstances, but it always represents the difference between the value of assets and the debt associated with them.
- Home equity, for example, represents the difference between the value of real estate and the mortgage payments that a homeowner is still required to pay. Similarly, company equity is the value of the assets owned by a company minus its debts – the amount of money that shareholders would receive if a company underwent total liquidation.
- Shareholder equity is used by investors as a key metric in assessing a company’s financial health, and therefore whether shares in the company represent a wise investment.
This article was written by Matt Ryan Webber from Money and was legally licensed through the Industry Dive Content Marketplace. Please direct all licensing questions to legal@industrydive.com.
