Equity represents the value of a company’s shares and plays an important role in assessing its financial health. Typically found on a company’s balance sheet, equity is calculated by subtracting total liabilities from total assets, providing a clear picture of a business’s net worth. This metric helps investors determine a company’s financial stability and potential for growth. A solid grasp of equity can lead to more informed investment decisions, especially when evaluating stocks. If you’re looking for personalized guidance in building your investment strategy, a financial advisor can help you navigate the complexities of equity and more.
Equity Explained
Equity represents the total cash value of an asset after accounting for any outstanding debts or liabilities. To determine equity accurately, subtract all liabilities from the asset’s value. This concept applies to both personal and corporate ownership. For example, if you own a car valued at $10,000 and still owe $3,000 on your loan, your equity in the vehicle is $7,000.
In a corporate setting, shareholder equity reflects the amount investors would receive if a company liquidated its assets and settled its debts. Individual equity, on the other hand, represents a single investor’s ownership stake in a company. The formula, however, remains the same: total company value minus liabilities equals shareholder equity.
For instance, if Grow Company holds $100 million in assets but carries $20 million in debt, its total shareholder equity is $80 million. And an investor with a 10% stake in the company would have $8 million in equity.
If a company’s liabilities exceed its assets, it results in negative equity, meaning shareholders’ stakes effectively hold no value. This doesn’t mean the company owes investors money, but rather that it must generate additional asset value before shareholders can expect a return.
Types of Equity
The larger a company is, the likelier it will include three separate shareholder classes. In each case, the standard definition of “equity equals the company’s total, value minus liabilities” applies:
- Owners Equity: This is the company value held by the owners themselves. In small businesses with one or a few owners, equity is not expressed as shares of stock. If the owners sell, company ownership is the total asset value minus any liabilities or outstanding loans. An owner who retains part of a company that goes public will still have shares, but total equity will then include the shares of all the other stockholders.
- Private Equity: This refers to owning shares in a private company. If a start-up company needs capital for investment or development, it may seek private equity investors, which may be individuals, a fund or a firm. These investors, typically wealthy, look for promising companies with strong growth potential. However, private equity also may buy into companies of low or negative value. In these cases, they may restructure or manage the companies until they return to profitability.
- Shareholder Equity: These are stocks available for sale on public exchanges. Each stock share represents a percentage of ownership in a company. The value of these shares rises and falls with company performance, with each share’s price inflating or deflating depending on market activity.
Differences Between Equity and Share Price
Shareholder equity is arguably what economists mean when they refer to a company’s “true value.” In a perfectly efficient market, the value of each share of stock would directly correlate to the company’s value. For example, if a company released 100 shares of stock, each share would be worth exactly 0.01 percent of the company’s total value after liabilities.
In reality, a company’s stock price reflects more than the firm’s shareholder value. It also reflects the perception of the marketplace. Prices rise and fall based on how investors treat the company’s stock on any given day.
The total value of all of a company’s outstanding shares, based on its current stock price, is the company’s market capitalization. A difference between a company’s shareholder equity and market capitalization reflects potential inefficiencies in the market. In a well-functioning market, these numbers should be roughly equal. If they’re significantly different, investors should expect stock prices to change.
That said, shareholder equity often lags behind market capitalization. If a company’s market capitalization stays consistently higher than it, though, then it’s because investors anticipate company growth. If that equation reverses, it indicates investors expect the company to lose value. But both cases are expressions of what the market and investors anticipate, rather than what is happening at the given moment.
Equity as Employee Compensation
Many companies use equity as a form of compensation. Any employee is eligible, which Starbucks demonstrated when it offered shares to its baristas. Employees who take stock options in developing companies can, over time, see substantial growth in these assets if their employer goes on to succeed.
Recruitment packages for executives frequently include equity as compensation. Companies may offer a specific monetary amount, based on the stock’s current share, or a set number of shares. That said, there often are conditions around when the new hire may actually own the shares.
Typically, equity-based compensation requires a vesting period, which is a specific amount of time before the employee owns or can sell the stock. The stock may come available in increments, vesting in stages over a term of years. This can encourage performance and provide incentives for the employee to stay with the company.
Start-ups that can’t pay high salaries often use stock options to recruit high-value talent. The shares in the business represent a lucrative payday should the company succeed and ultimately go public. But it’s not guaranteed money. Should the company fail, the stock options dissolve.
Bottom Line
Equity is part of everyday life for every stock market investor and many loan holders. It represents the current cash value of an asset, whether it’s a share of stock, a house or a business. But it also may express potential value, such as when an employee buys or is given shares in a startup. With stocks, investors should keep an eye on market capitalization as well as the stock price. A discrepancy between these may indicate the company’s performance is changing.
Tips for Investors
- Determining the role stock plays in your investment strategy can be easier when you have some professional guidance. A financial advisor can help set your investment strategy and manage your investments for you. Finding the right financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Stock equities are not just for individual investors. Many funds and annuities index their portfolios to equity value, and they can be strong performers. But there are many other investment opportunities, such as bonds, mutual funds and commodities beyond jumping into the stock market.
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