Equity (finance)

Equity in finance generally refers to an ownership interest or to the residual value that remains after obligations are deducted from assets. The term is used in accounting, corporate finance, investing, real estate, lending, and business ownership.

In financial accounting, the Financial Accounting Standards Board describes equity or net assets as the residual interest in an entity's assets after its liabilities are deducted.

A simplified accounting formula is:

<math>\text{Equity} = \text{Assets} - \text{Liabilities}</math>

Equity does not necessarily equal the amount for which a business, property, or investment could be sold. Accounting measurements, market conditions, taxes, transaction costs, and contractual rights can cause substantial differences.

Accounting equity

On a balance sheet, equity represents the residual claim after reported liabilities are subtracted from reported assets.

The U.S. Securities and Exchange Commission explains that shareholders' equity is sometimes called capital or net worth and represents the amount that would remain for shareholders if a company's assets were sold and its liabilities paid, subject to the accounting values presented.

The accounting equation is:

<math>\text{Assets} = \text{Liabilities} + \text{Equity}</math>

Equity is therefore a residual amount. An increase in assets does not automatically increase equity when an equal liability is also created.

For example, if a company borrows $100,000 and receives $100,000 in cash, its assets and liabilities both increase by the same amount. Its equity is initially unchanged.

Shareholders' equity

For a corporation, equity is commonly called:

• shareholders' equity;
• stockholders' equity;
• owners' equity;
• book equity;
• net assets.

Shareholders' equity may include:

• common stock;
• preferred stock;
• additional paid-in capital;
• retained earnings;
• accumulated other comprehensive income or loss;
• treasury stock as a reduction of equity;
• noncontrolling interests when separately presented.

The SEC notes that a statement of shareholders' equity shows changes in shareholders' interests over time.

Common stock and ownership

A share of stock represents an ownership position in a corporation. Investor.gov describes stock as an instrument representing equity ownership and a proportional claim on a corporation's assets and profits.

Stock ownership can provide rights such as:

• participation in certain corporate votes;
• potential dividend payments;
• the possibility of capital appreciation;
• a residual claim on assets after creditors and higher-priority claims are satisfied.

Ownership rights vary according to the class of stock, corporate documents, applicable law, and contractual arrangements.

Common shareholders normally rank behind creditors and often behind preferred shareholders if a corporation is liquidated.

Components of equity

Contributed capital

Contributed capital is value provided by owners in exchange for ownership interests. For a corporation, this can include the stated value of shares and amounts received above stated or par value.

Issuing new shares can increase total equity, although it can reduce the percentage ownership of existing shareholders.

Retained earnings

Retained earnings represent cumulative earnings retained in the business rather than distributed to owners, adjusted for prior losses and certain accounting changes.

A simplified formula is:

<math>

\text{Ending retained earnings} = \text{Beginning retained earnings} + \text{Net income} - \text{Dividends} </math>

A company can have positive retained earnings but limited cash because earnings may have been invested in inventory, equipment, receivables, acquisitions, or other assets.

Accumulated other comprehensive income

Certain gains and losses may be recorded outside net income in other comprehensive income. Their cumulative effect can appear within equity.

The precise treatment depends on the applicable accounting standards and the nature of the item.

Treasury stock

Treasury stock represents a company's own shares that it has reacquired and not retired. Under common accounting presentations, treasury stock reduces shareholders' equity.

A share repurchase can therefore reduce both cash and total equity.

Book value

Book value of equity generally refers to the amount of equity reported on the balance sheet.

Book value per common share may be calculated as:

<math>

\text{Book value per common share} = \frac{\text{Common shareholders' equity}} {\text{Common shares outstanding}} </math>

This measure differs from a company's share price and total market capitalization.

Book value is based on accounting measurements, while market value reflects the price investors are willing to pay for ownership interests.

Market value of equity

Market value of equity, commonly called market capitalization for a publicly traded company, is generally calculated as:

<math>

\text{Market capitalization} = \text{Share price} \times \text{Shares outstanding} </math>

Market capitalization can differ greatly from book equity because investors consider expected earnings, growth, risk, intellectual property, brand strength, competitive position, and other information not fully represented by accounting balances.

Market capitalization also changes with the share price, while book equity changes through accounting transactions and recognized events.

Negative equity

Equity is negative when reported liabilities exceed reported assets.

Negative equity can result from:

• accumulated operating losses;
• large distributions to owners;
• asset impairments;
• substantial borrowing;
• share repurchases;
• pension or other comprehensive losses;
• business restructuring;
• accounting remeasurements.

Negative accounting equity does not automatically mean that an entity is unable to continue operating. It does, however, indicate that reported liabilities exceed reported assets under the accounting measurements used.

Liquidity, cash flow, debt maturities, profitability, access to financing, and asset values must also be evaluated.

Home equity

In real estate, home equity is generally the difference between a property's estimated market value and debt secured by the property.

<math>

\text{Home equity} = \text{Estimated property value} - \text{Mortgage and secured debt} </math>

For example, a home valued at $300,000 with a $190,000 mortgage balance would have an estimated $110,000 of gross home equity.

Actual proceeds from selling the property could be lower after commissions, taxes, repairs, closing costs, liens, and market-price changes.

Home equity can increase through:

• mortgage principal payments;
• property-value appreciation;
• renovations that increase market value;
• repayment of other secured debt.

It can decrease through falling property values, additional borrowing, or deterioration of the property.

Private equity

Private equity can refer to ownership interests in companies whose shares are not publicly traded or to investment funds that acquire and manage such interests.

Investor.gov describes a private equity fund as a pooled investment vehicle managed by an adviser that invests on behalf of participating investors, often with long investment horizons and holdings that can take time to sell.

Private-equity investments can involve:

• leveraged buyouts;
• growth investments;
• venture capital;
• distressed investments;
• minority ownership stakes;
• operational restructuring.

Private equity should not be confused with the accounting equity reported by every business. One describes a category of ownership investment; the other describes a residual financial-statement amount.

Equity financing

A company uses equity financing when it raises capital by issuing ownership interests instead of borrowing.

Possible advantages include:

• no required principal repayment;
• no mandatory interest payment;
• greater financial flexibility;
• sharing business risk with investors.

Possible disadvantages include:

• dilution of existing ownership;
• sharing future profits;
• potential loss of voting control;
• securities-law and disclosure requirements;
• pressure from new investors.

Debt financing creates an obligation to repay borrowed funds. Equity financing creates or expands ownership interests.

Return on equity

Return on equity measures income relative to shareholders' equity.

A common formula is:

<math>

\text{Return on equity} = \frac{\text{Net income}} {\text{Average shareholders' equity}} \times 100 </math>

Average equity is often used because the balance can change during the reporting period.

Return on equity can increase because of improved profitability, but it can also rise when equity is reduced through borrowing, losses, or share repurchases. The ratio should therefore be interpreted with leverage, cash flow, margins, and asset returns.

Equity versus enterprise value

Equity value represents the value attributable to owners. Enterprise value attempts to measure the value of the underlying business operations available to capital providers more broadly.

A simplified enterprise-value formula is:

<math>

\text{Enterprise value} = \text{Equity market value} + \text{Debt} - \text{Cash} </math>

More detailed calculations may include preferred stock, noncontrolling interests, leases, pension obligations, investments, and other adjustments.

Limitations

Equity is affected by accounting policies and estimates, including:

• asset measurement;
• depreciation and amortization;
• impairment;
• pension assumptions;
• foreign-currency translation;
• business combinations;
• tax accounting;
• share-based compensation;
• classification of financial instruments.

Reported equity should not be treated as an automatic estimate of liquidation proceeds or company value.

A complete analysis may require the balance sheet, income statement, cash-flow statement, statement of shareholders' equity, financial-statement notes, and current market information.

See also

• Asset
• Net income
• Earnings before interest and taxes
• Parent company
• Subsidiary
• Types of business entity
• Ticker symbol
• Nasdaq