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Equity

EquityTypically found on a company’s balance sheet, equity is one of the most common financial metrics used to evaluate a company’s financial health.

What Is Equity?

It is the difference between the value of a company’s assets and the value of its liabilities. The formula is:

Assets Value – Liabilities Value

If someone owns equipment worth $10,000 (an asset) but owes $7,000 on a loan against that equipment (a liability), the equipment represents $3,000 of equity. If liabilities exceed assets, equity can be negative.

The types of equity are as follows:

  • Shareholders' equity: The equity of a company as divided between the shareholders.

  • Private equity: A stock or any other security representing an ownership interest in a private company.

  • Real estate: Property's current fair market value minus the amount that the owner still owes on the mortgage.

  • Margin: Difference between the value of securities in a margin account and what the account holder borrowed from the brokerage.

  • Liable (risk) capital: When a business goes bankrupt and has to liquidate, equity is the amount of money remaining after the business repays its creditors.

Shareholders' Equity

This type of equity includes the following:

  • Common stock – the type of stock that exists in every company.

  • Paid-in capital – the amount that the shareholders pay for company stock shares.

  • Additional paid-in capital - capital that represents the extra amount that the shareholders have invested in the common stock or preferred stock accounts.

  • Retained earnings - net income that a company either reinvests in the business or uses to pay the debt. The shareholders receive the rest as dividends.

  • Treasury stock - the stock that a company has either repurchased or never issued. It can be sold at a later date.

The formula of SE is:

Total Assets Value – Total Liabilities Value

Private Equity

In general, PE refers to companies that are not publicly traded and involves funds that are not noted on a public exchange. PE comes from funds and investors that directly invest in private companies. It is typical for young companies and startups that get funded by investors. Unlike shareholder equity, PE is not suitable for an average individual. Only investors with a net worth of at least $1 million can join the PE or venture capital partnerships.

There are the following types of PE:

  • Venture capital. When the company has finally created its product or service and is ready to enter the market, venture capital comes into play. Some of the tech giants such as Apple Inc. and Dell Technologies started as venture-funded organizations. A venture capitalist may be a member of the board of directors for its portfolio companies.

  • Leveraged buyout (LBO). A company receives a loan from a PE firm to fund the acquisition of a division or another company. The loan is typically secured by cash flows or company assets.

  • Mezzanine debt. This is a private loan that is typically provided by a commercial bank or a mezzanine venture capital firm. Mezzanine transactions often unite debt and equity in the form of a subordinated loan, warrants, common stock, or preferred stock.

The main features of PE are typical as follows:

  • It restructures the acquired company and tries to resell it at a higher value, aiming for a high return on equity. Return on equity (ROE) is a financial performance metric, which is calculated by dividing net income by shareholder equity. The ROE is considered a measure of how much profit the company’s shareholder equity can generate.

  • It actively uses debt financing to purchase companies. Debt financing reduces corporate tax burdens and is one of the principal ways in which profits are made for investors.

  • PE investors often combine their transactions with those of other buyers to benefit from diversification of different target risk types, a combination of additional investor information and skill sets, an increase in the flow of future deals.

Real Estate Equity

REE can be compared with property ownership. The amount of equity someone has in their property represents how much of the property they own upright. Equity on a property is derived from payments made against a mortgage, including a down payment, and from increases in property value.

For example, a house with a mortgage has a current market value of $100,000 and the owed mortgage is $30,000. The REE is worth $70,000 and the formula is $100,000 (asset) - $30,000 (liability).

Equity Investment

Equity investment is buying and holding shares of stock on a stock market by companies and individuals to get income from capital gains and dividends. The market price per share does not match the equity per share calculated in the accounting statements. Accounting equity can be potentially negative, but the market price per share is never negative because the limited liability principle guarantees that a shareholder's losses may never exceed their investments.

According to the "Merton model", the stock equity value is modeled as a call option on the value of the entire company including the liabilities, and the equity market value thus depends on the volatility of the company assets market value. Equity may be generally viewed as a call option on the company. As the principle of limited liability protects equity investors, shareholders would choose not to repay the company's debt where the company value is less than the value of the outstanding debt. If the company value is greater than the debt value, the shareholders would choose to repay and not to liquidate.

Summary

The difference between the value of a company’s assets and the value of its liabilities is called equity. There are the following types of equity:

  • Shareholders' equity

  • Private equity

  • Real estate

  • Margin

  • Liable (risk) capital

Shareholders’ equity typically includes the common stock, paid-in capital, additional paid-in capital, retained earnings, and treasury stock. Private equity is subdivided into venture capital, leveraged buyout, and mezzanine debt. Equity investments refer to acquiring and holding the shares on a stock market by companies and individuals to get income from capital gains and dividends.