What is Equity?

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Definition:

Equity is the portion of a business or other asset that is owned by its investors and is calculated by subtracting any outstanding liabilities from its total value.

🤔 Understanding equity

Equity is the portion of a business or other asset that belongs to its owners. It is calculated by taking the total value of the asset and subtracting any outstanding liabilities, like bills and taxes. It can be found on most companies’ balance sheets and is used to determine their health. Equity can be split among multiple owners, the same way big companies often have many shareholders.

Example

In its Second Quarter 2019 financial statement, Tesla listed its shareholder equity as about $5.7B. To calculate that number, the company would take the value of its assets, around $31.8B, and subtract its liabilities, about $24.7B. Since Tesla is also the majority owner of a few subsidiary companies, some of which have minority owners, it must factor out the minority owners’ equities, about $1.4B, before calculating its shareholders’ equity. Consequently, Tesla shareholder equity was equal to $31.8B - $24.7B - $1.4B. That’s approximately $5.7B, same as the value reported on their balance sheet. That’s how much money would be paid out to shareholders if Tesla were liquidated overnight. Source: Tesla Q2 Report

Takeaway

Equity is like a pie that you bought with a friend...

Neither of you owns the entire pie, and each of you is only entitled to eat a portion of the pie equal to the percentage of the pie that you paid for. Likewise, ownership in a company or other asset is based on the percentage that a person paid for. Subtracting the company’s liabilities from its assets and then multiplying it by the person’s ownership percentage reveals their equity’s dollar value.

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How is equity calculated?

To find the total ownership equity in a company, you would use this formula: owner’s equity = assets - liabilities.

If a company has more than one owner, you can determine the value of each person’s ownership stake by identifying the total equity in the company and then multiplying it by the percentage of the company that a person owns. For example, let’s say a fictitious company called Joe’s Lemonade had $1M in assets, $0.5M in liabilities, and five owners with equal shares. A single owner would have equity in the company that was equal to ($1M-$0.5M) * 20 percent, or $100,000.

What are the different types of equity?

Common stock is a type of stock that typically comes with voting rights, allowing shareholders to vote on major business decisions. It also may pay dividends if the company does well.

Preferred stock often has no voting rights, but comes with other benefits that make it more desirable than common stock. Companies pay preferred shareholders their dividends at a fixed rate, as opposed to the variable, lower price paid to common stockholders. Preferred shareholders also get priority claims to dividends.

Private equity represents investments in companies that aren’t publicly traded.

Contributed surplus is the money raised by issuing shares at a price above the par value. Par value is the face value of each stock that’s set by the company’s corporate charter. By setting par value price, the company promises not to issue any shares below that. That’s why par value is often listed quite low.

Imagine a stock has a par value of $10. If a company sells 100,000 shares for $25 each, they will receive $2.5M. The par value of the stock sold in this case would be $10 * 100,000, or $1M. This $1M is considered common stock equity, while the remaining amount, the $1.5M, is considered contributed surplus. The entire $2.5Mis often referred to as shareholders’ equity.

Retained earnings are the profits that companies earn, minus any dividends or other payments made to investors. The company uses this money to fuel its growth through capital expenditures, research and development, marketing, or even acquisitions.

Treasury stock is stock that a company sold and later repurchased. These repurchases decrease the total outstanding shares on the market. Since these stocks are no longer owned by shareholders, treasury stock reduces shareholders’ equity.

Home equity is the portion of the house’s value owned by the homeowner. It can be calculated by subtracting outstanding loans from the house’s entire value.

How does equity financing work?

If a company needs to raise money, it has a few options. One option is equity financing, the selling of the company’s stock.

Before they are large enough to have an IPO (initial public offering) and sell their stock on the stock market, many companies make use of private equity. Private equity is when a founder sells a portion of their company to raise funds. For example, an entrepreneur invests $100,000 to start a company. Later, he or she needs to raise more money to grow the company and convinces an outside investor to invest another $50,000. They agree that a share is worth $1.00. The company is now worth $150,000. The founder owns 66.7 percent of the shares, while the new investor owns the remaining 33.3 percent.

While the entrepreneur has to give up some of the ownership, they can use the money they raise to grow the company.

Equity financing is also valuable for companies that aren’t yet turning a profit, as it allows them to avoid debt. Since loans have to be paid back with interest, companies that take on debt find it that much harder to turn a profit. Investors, who buy shares of a company, give the company money in exchange for a percentage of future profits.

What is the difference between stocks and equity?

Stock is a type of equity. This means that all stocks are equity, but not all equity is stocks.

Equity refers to a portion of a company that is owned by its investors. Most common type of equity is shares of stock that can be bought and sold on the stock market. Stock represents a business’s total ownership. Stock is broken down into many shares, each of which has an equal amount of ownership in a business.

But, as we discussed above, equity in a company can also include other items such as retained earnings and business equity.

Why should I invest in equities?

Like all investments, equities come with risks, but their benefits make them especially attractive to many investors.

For one, equities’ value can rise over time. Well-managed businesses generally make more money as time goes on. If you were to invest in one and then sell your share years later, you could make a profit on the sale.

You might also make money off of your investment through dividends. When companies perform well, they pay out a portion of their profits to their shareholders. That means you could receive a percentage of your investment back each quarter. That produces a revenue stream and could lead to a profit without selling the original shares.

However, dividends and growth in the value aren’t guaranteed. If the company performs poorly, you could see a decrease in your shares’ value and lose them altogether if the business goes bankrupt.

Ready to start investing?
Sign up for Robinhood and get your first stock on us.Certain limitations apply

The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory.

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