Stockholders’ equity refers to the assets of a company that remain available to shareholders after all liabilities have been paid. This number can be positive or negative. Positive stockholder equity can indicate that a company is in good financial health, while negative equity may hint that the company is struggling or overextended with debt. Stockholders’ equity is typically included on a company’s balance sheet but it’s possible to calculate it yourself.
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Understanding Stockholders’ Equity
Stockholders’ equity measures the ratio of assets to liabilities in a company. It can also be referred to as shareholders’ equity, owner equity or book value. All of these terms mean the same thing. In terms of its application, stockholders’ equity can be used to generate a financial snapshot of a company at any given point in time. Specifically, this metric can be used to evaluate the likelihood of receiving a payment should the company have to liquidate.
When liquidation occurs, there’s a pecking order that applies which dictates who gets paid out first. Debt holders take precedence ahead of equity holders. Calculating stockholders’ equity can give investors a better idea of what assets might be left (and paid out to shareholders) once all outstanding liabilities or debts are satisfied.
How to Calculate Stockholders’ Equity
Calculating stockholders’ equity is relatively simple. You’d use this formula to find it:
Stockholder’s equity = Total company assets – Total company liabilities
As long as you know what a company’s assets and liabilities are, you can find the amount of stockholders’ equity that exists. Total assets can include both current and non-current assets. Current assets are highly liquid and include things like inventory, cash or outstanding receivables. Non-current assets are things that cannot be converted to cash quickly, such as trademarks or other intellectual property that a company owns.
The total liabilities referenced in the above formula represent all of a company’s current and long-term liabilities. Short-term debts generally fall into the current liabilities category, as these are things that a company is most likely to pay in the near future. Longer-term liabilities are ones that take longer than one year to clear.
Here’s a very simple example of how the formula works. Say that you’re considering investing in a company that has $5.3 million in total assets. Total liabilities, meanwhile, come to $3.4 million. To find stockholders’ equity, you’d just do some simple math:
$5,300,000 in total assets – $3,400,000 in total liabilities = $1.9 million in stockholders’ equity
You’d need to be able to read a balance sheet to find the company’s total assets and liabilities in order to make these calculations. But overall, it’s a much less complicated formula than other calculations that are used to evaluate a company’s financial health.
Alternative Method to Calculate Stockholders’ Equity
If, for some reason, you’re unable to find a company’s balance sheet or access information about its assets and liabilities, there’s another method you can use to calculate stockholders’ equity. Here’s what the formula would look like:
Stockholders’ equity = (Book value common stock + preferred stock + unrealized gains/losses + paid-in capital +/- retained earnings) – Treasury stock
Paid-in capital is the money that a company receives when investors buy shares of its stock. In exchange for that capital, investors claim an equity stake in the company. Retained earnings are the part of a company’s profits that it keeps for reinvestment after dividends and other distributions are paid to investors.
Retained earnings can increase over time, potentially surpassing the amount of paid-in capital. It’s possible for retained earnings to represent the largest share of owner equity if growth substantially outpaces the amount of capital paid in.
How to Interpret Stockholders’ Equity
At a glance, stockholders’ equity can give you an idea of how well a company is doing financially and how likely it is to be able to pay its debts. That, in turn, can help you to decide if a company is worth investing in, based on your goals and risk tolerance.
Why do companies end up with negative stockholders’ equity? There are different factors that can contribute to this scenario. For instance, negative equity can be the result of the company:
- Carrying too much debt
- Buying back large amounts of its common stock
- Paying out excessive dividends to investors
Whether negative stockholder’s equity is indicative of a larger problem usually requires taking a closer look at the company’s financials. Buybacks, for example, can push stockholders’ equity into negative territory in the short term but benefit the company financially in the long run.
On the other hand, if a company is significantly overextended with loans and other debts that’s a sign that it may be in trouble. Negative stockholders’ equity in that situation may be further compounded by negative cash flow.
Limitations of Using Stockholders’ Equity to Evaluate Companies
Stockholders’ equity is a helpful calculation to know but it’s not foolproof. It’s important to remember that it may not reflect the amount that would be paid out to investors following a liquidation with 100% accuracy.
As far as limitations go, there are a few, starting with the fact that certain assets may not show up on a balance sheet. For example, it may be difficult to assign a dollar value to the expertise and knowledge that a company’s CEO brings to the table. Likewise, the value of a brand can be equally difficult to measure in concrete terms.
There may also be issues with accurately assessing the fair market value of assets that are included in the balance sheet. The book value assigned to fixed assets may be higher or lower than market value, depending on whether they’ve appreciated or depreciated over time.
Finally, there’s the unknown to consider. A balance sheet can’t predict changes in the value of a company’s assets or changes to its liabilities that haven’t occurred yet. Increases or decreases on either side could shift the needle substantially when it comes to the direction in which stockholders’ equity moves.
Understanding stockholders’ equity and how it’s calculated can help you to make more informed decisions as an investor. While it’s not an absolute predictor of how a stock might perform, it can be a good indicator of how well a company is doing. Before making any investment, you’ll want to perform the proper analysis or find an advisor who can help you make those decisions.
- Investing in stocks can help you build wealth, but it’s important to choose the right stocks for your portfolio. If you’re new to the markets, that’s something a financial advisor can help you with. An advisor can review your goals, time frame for investing and risk tolerance to create a personalized strategy that meets your needs. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you’re interested in creating passive income from investments, you might consider dividend stocks. These are stocks that pay out a portion of profits to investors. Looking at stockholders’ equity, along with cash flow ratios and expected earnings growth, can give you a better idea of whether a company’s dividend payout is sustainable and/or likely to increase in the future.
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