What is Equity | Understand Equity | Equity Meaning & Definition

Last Updated: July 30, 2021

Table of Contents

• Understand Equity
• Understanding Shareholder Equity
• Components of Shareholder Equity
• Example of shareholder equity
• Other Forms of Equity
• Private Equity
• Brand Equity
• Equity vs. Return on Equity

Understand Equity

Wondering about the equity meaning? This is a basic concept that you should be familiar with, when it comes to investing. Buying equity shares is after all a preferred activity for most investors in the stock market. However, have you wondered what is equity or what is equity share? Looking at the deep-rooted meanings behind these terms and concepts, particularly the equity shares meaning, the meaning of equity shareholders and overall ownership meaning will help you greatly with regard to obtaining handy market knowledge and building a good investment strategy for the future.

Understanding Shareholder Equity

The equity definition is tied to the concept of shareholder equity. This is also called stockholders’ equity at times and is vital to understand if you are keen on making equity investments in the future. It basically represents the residual claim of the owner of the corporation on assets after payment of all debts. Shareholder equity is thus equal to the total assets of a firm minus its overall liabilities. This will help you gauge the creation of any shareholders fund and also work out owner’s equity and other equity share capital aspects.

This is different from debt to equity ratios, i.e. the ratio of how much debt exists for the corporation in relation to its overall equity reserves or assets. If shareholder equity is positive, then the company will have ample assets for ensuring coverage of all its liabilities. However, if this is negative, then the liabilities of the company will surpass its overall assets. Retained earnings is another one out of the types of equity shares and is a part of shareholder equity as the percentage of net earnings that were not paid out to shareholders in the form of dividends and this should not be confused for cash or other similar liquid assets. Years of retained earnings may be used for meeting expenditure or any type of asset for business growth. Shareholders’ equity for any entity which is a going concern is not similar to liquidation value. For liquidation, values of physical assets have been lowered and there is the existence of other conditions which qualify as extraordinary.

Many investors thus perceive companies with negative shareholder equity as unsafe or riskier investments. Shareholder equity is not any definitive indication of the financial health of a company. If used in fusion with other metrics and measurement parameters, investors may accurately analyze organizational health with this metric. All data required for computing the shareholder equity of a company is readily available on the balance sheet. Total assets are inclusive of non-current and current assets. The latter are those assets which may be converted into cash within a period of one year, i.e. accounts receivable, cash and inventory. Long-term assets are those that cannot be converted into cash or consumed within a year’s time, i.e. property and investments, equipment, plants and intangible aspects like patents. Total liabilities will include long-term and current liabilities. The latter will indicate debts usually due for repayment within a year’s time, i.e. taxes payable or accounts payable and the former will be obligations due for repayment in periods exceeding one year, i.e. leases, bonds payable, pension obligations and so on. Upon calculation of total liabilities and assets, shareholder equity may be worked out likewise. Shareholder equity is a vital parameter for working out the generated return against the amount that is invested by equity investors.

Components of Shareholder Equity

There are several components of shareholder equity which you should know about. These include the following:

Outstanding Shares- The number of outstanding shares is a vital part of shareholders’ equity. It is the company stock volume sold to investors and not repurchased by the entity. It is representative of the total stock amount issued by the company to company officers, public investors and company insiders inclusive of restricted shares. It also covers the par value for common stock and preferred shares sold by the company. Outstanding shares are the vital aspect for calculations like EPS (earnings per share) and market capitalization.

Additional Paid-in Capital- Shareholders equity also includes the money paid for shares of stocks above the par value and this is known as APIC (additional paid-in capital). This figure comes from the difference between the par value of common and preferred stock and the price that each was sold for along with newly sold shares as well. APIC happens only when investors directly buy shares from any entity. They represent additional amounts paid by investors for company shares over the share face value during the IPO (initial public offering).

Retained Earnings- When any company retains its income instead of paying it out in the form of dividends to shareholders, a positive balance happens in the retained earnings account. These are often used for paying off any debt or reinvesting in the company itself. The figure is covered under shareholders’ equity and is the biggest item in the calculation usually. Companies may call this as retained surplus or even retention ratio at times.

Treasury Stock- Treasury stock is the number of shares repurchased by the company from investors. A company will hold onto its own stocks in the treasury for future use. It may sell the entire stock in the future for raising capital or may use the same for warding off any takeovers. This stock lowers equity of shareholders on the balance sheet of the company. It is deducted from total equity of the company.

Example of shareholder equity

A simple example will suffice. Suppose a company is XYZ Ltd and it manufactures a particular household product. Based upon an annual report, the figures stand as the following for the year ending on 31st December. Given, Total Assets- Cash & Cash Equivalent + Accounts Receivable + Net Property, Plant & Equipment + Inventory

This stands as Rs, 50,00,000 + Rs. 4,000, 0000 + Rs. 2,000,000 + Rs. 35,00,000.

Hence, the total assets will stand at Rs. 6,85,00,000/-

Again, there will be the Total Liabilities- Total Long Term Debt + Total Short Term Debt + Accounts Payable + Other Current Liabilities

This will be suppose Rs. 80,00,000 + Rs. 40,00,000 + Rs. 60,00,000 + Rs. 1,000,000.

Hence, total liabilities will be 2,80,00,000/-

Hence shareholder equity for XYZ Ltd will be Total Assets – Total Liabilities.

This will be Rs. 6,85,00,000/- (-) Rs. 2,80,00,000/- = Rs. 4,05,00,000/-

This indicates positive net shareholder equity which is a major draw for investors.

Other Forms of Equity

Common Stock- Common stock is representative of the shareholder’s or owner’s investment in the business as a form of capital contribution. The account is representative of the shares entitling owners to vote along with their residual claim on the assets of the company. The common stock value equates to the par value of the shares times the number of shares which are outstanding. For instance, 1 million shares with Rs. 1 in par value will be Rs. 1 million of common share capital on the balance sheet of the company.

Preferred Stock- Preferred stock is similar to common stock, being a share type which often does not have voting rights but a cumulative dividend is guaranteed. If the divided is not paid out in a year, then it will keep accumulating until it is paid off. Suppose a company’s preferred share will get Rs. 10 in cumulative dividends in a year. The company has declared a dividend for the current year although it had not paid dividends over the last couple of years. Hence, this share will get Rs. 30 (Rs. 10*3) in total dividends for the current year.

Contributed Surplus- Contributed surplus is the amount paid over the par value that is paid in turn by investors for stock purchases with a par value. This account will also hold various kinds of losses and gains, leading in sale of shares or complex financial market instruments.

Additional Paid-In Capital- Additional paid-in capital is another term used to denote contributed surplus.

Private Equity

Private Equity is an alternative class of investments and comprises of capital which has not been listed on any public exchange. Private equity comprises of investors and funds which directly invest in private entities or those engaging in buyouts of public entities, leading to delisting of public equity. Retail and institutional investors offer capital for private equity and this may be tapped for funding new technologies, making new acquisitions, expanding working capital and also beefing up and solidifying the balance sheet. Private equity fund will have LP (Limited Partners) who usually own 99% of shares in a fund with limited liability and GP (General Partners) who have 1% of shares with full liability. The latter are also responsible for investment operation and execution. Amongst benefits of private equity, there is easier access to alternate capital forms for company founders and entrepreneurs alike along with lower quarterly performance stress alongside. These benefits are offset by the aspect that valuations of private equity are not set with market forces. Private equity may adopt multiple forms right from venture capital to complicated leveraged buyouts.

Brand Equity

Brand equity indicates the value premium generated by a company from a product which has a recognizable name in comparison to any generic equivalent. Companies may build brand equity for products by making them highly recognizable and superior in terms of reliability and quality. Mass marketing campaigns also help greatly in building brand equity. Whenever any company witnesses positive brand equity, customers pay high prices for products although they did not receive a similar thing from competitors at a lower rate. Customers pay a price premium for business with a firm they admire and know about. A company with brand equity does not incur higher expenditure than competitors for manufacturing a product and bringing it to the market. The difference in price will go to the margin. The brand equity enables a higher profit per sale. This is the value from name recognition and it has three aspects, i.e. negative or positive impact, consumer perception and resulting value. Brand equity leads to higher profitability when customers are drawn towards highly reputed services or products.

Equity vs. Return on Equity

Equity & its calculation

Equity is usually called shareholders’ equity or owners’ equity for privately held entities. It represents the amount of money that is returned to the shareholders of a company if the assets were entirely liquidated and all debt of the entity paid off via liquidation procedures. In case of acquisitions, it is indicative of the value of the company sale after deducting liabilities owed by the entity that are not transferred with this sale. Alongside, shareholder equity may also indicate the book value of any company. Equity may sometimes be offered as payment in kind and is also representative of pro-rate ownership of shares of a company. Equity may be found on the balance sheet of a company and is one of the commonest data pieces used by analysts for working out any entity’s financial health. Equity is thus indicative of some degree of residual ownership in any firm or asset post subtraction of all debts linked to the asset in question. Equity is representative of the stake of shareholders in the company, as identified on the balance sheet of the company. The calculation of equity in the total assets of the company minus the total liabilities of the company will be used for various crucial financial calculations including the ROE (Return on Equity) as well. The formula for calculation or working out equity of any firm is the following-

Shareholders’ Equity = Total Assets – Total Liabilities.

This information is given on company balance sheets where the steps to be followed include locating all assets of an entity on the balance sheet for a particular duration, locating overall liabilities which should be separately listed on the balance sheet too and subtraction of overall liabilities from the total assets for working out the final shareholder equity. You should make a note of the fact that total assets will be equal to the sum of the total equity and liabilities. Shareholder equity may also be indicated in the form of the company’s share capital and retained earnings subtracted from the treasury share values. This method is not as common and although both methods will give you the same result, the usage of total liabilities and total assets is more indicative of the financial health of any company.

Return on equity & its calculation

ROE (return on equity) is a measurement of financial performance that is calculated through the division of net income by shareholder equity. Since equity of shareholders is equivalent to the assets of a company minus the total debts, ROE will be taken as the return on the net assets. ROE is perceived as the measure of the profitability of a corporation in relation to the equity of stockholders. ROE is helpful in measuring profitability of a corporation as a result as related to equity of stockholders. Whether any ROE is taken as satisfactory or not will be dependent upon what is regular for the peers of the company or the industry at large.

Depending upon whether investors choose a shortcut method, they may take ROE as nearer to the long-term average of the S&P 500 (14%) as the acceptable calculation ratio with anything lower than 10% being considered as poor. ROE is shown in the form of a percentage and may be calculated if net income and net equity are both positive figures for any entity. Net income is worked out prior to dividends paid out to common shareholders and after dividends are paid out to preferred shareholders along with interest due to lenders. The calculation formula will be the following:

Return on Equity = Net Income/Average Shareholders’ Equity

Net income is the amount of income after taxes and net expenses generated in any given duration. Average shareholders’ equity is worked out by addition of equity at the beginning of this duration. The end and beginning of the particular period should be coinciding with the period in which the net income is earned by the company. Net income over the last complete financial year or trailing 12 months, can be found in the income statements and represents the sum of all financial activity in a particular period. Shareholders’ equity comes from the balance sheet, i.e. the running balance of any company’s entire history of asset and liability changes in the balance sheet. The best practice method is calculation of ROE on the basis of average equity over a duration owing to mismatch between balance sheet and income statement.