In the context of finance and business, equity refers to the value of a company’s ownership shares. This is most often utilized in the context of a company’s balance sheet, and there is a specific calculation that dictates its valuation. More specifically, equity is the complete, liquid value of a company minus any applicable debts or liabilities. Knowing exactly what this term means is essential to understanding a company’s finances. In turn, if you better understand a company’s financial situation, you’ll be able to make more educated investment decisions about its stock. If you need hands-on help with your investments, consider working with a financial advisor in your area.
What Is Equity?
Equity is the total, liquid cash value of an asset. But to accurately calculate that value, you need to account for any debts or other liabilities first. The total equity is the value minus all liabilities. This definition may apply to personal or corporate ownership. For instance, if you own a car, its value is the current resale value minus the amount of any outstanding car loan. So a car worth $10,000 with an outstanding $3,000 loan has $7,000 in equity.
With corporate ownership, shareholder equity refers to the amount of cash value a company’s stock would return to its all of its owners upon liquidation. Individual equity is simply a single investor’s share of ownership. But in either case, the formula is the same: The total company value, minus debts and liabilities, equals the cash value.
So imagine Grow Company has $100 million in total cash and salable assets and $20 million in debt. The shareholder equity is $80 million. Meanwhile, an individual owning 10% of Grow Company would have $8 million worth of equity in the firm.
If a company’s liabilities are greater than its assets, it has negative equity and the value of all shareholders’ stakes is zero. In other words, it wouldn’t actually owe any money to anyone. The negative amount reflects the asset value the company would need to create before its investors could see a return.
What Are the Different 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:
- Owner 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 ownership 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 rise and fall with company performance, with each share’s price inflating or deflating depending on market activity.
What’s the Difference 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 in the given moment.
Using 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 success.
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 term of years. This can encourage performance and provide incentive 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 represents a lucrative pay day should the company succeed and ultimately go public. But it’s not guaranteed money. Should the company fail, the stock options dissolve.
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 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 is easier when you have some professional guidance. Finding a financial advisor that can help you out doesn’t have to be hard, though. SmartAsset’s free financial advisor matching tool connects you with up to three financial advisors in your area in just five minutes. 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 a 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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