What does equity mean?
Learn about equity and how it can help shareholders in fundamental analysis. See why it is one of the most important pieces of data when it comes to evaluating a company's financial health.
Equity can be defined as the amount of money the owner of an asset would be paid after selling it and any debts associated with the asset were paid off.
For example, if you own a home that's worth $200,000 and you have a mortgage of $50,000, the equity in the home would be worth $150,000.
In investing terms, equity investors purchase stock for a share of ownership in companies with the expectation that the stock may earn dividends or can be resold with a capital gain. If the investment were to rise in value, the equity they could get for selling it potentially increases.
It’s important to note that equity stakes rise or fall with the underlying value of the company's assets as well as other factors.
What are the different kinds of equity?
While there are many different kinds of equity, we will focus on some common types of equity in investing and business.
Shareholder equity – When an investor invests in a company, they can claim to own a very small piece of the company. This is known as shareholder equity. As an equity shareholder, you are entitled to a share of the company profits when those profits are returned to the shareholder.
Home equity – This can be defined as the current market value less any outstanding debt. This can be calculated by subtracting the mortgage and other debt owed against the home from the total value of the home.
Private equity – This is the evaluation of a company that is not publicly traded. This applies where stated equity on a private company's balance sheet is what remains after subtracting liabilities from assets. Privately held companies sell shares directly to investors via private placements. Private placements typically require large minimum investment and may have other requirements or conditions of purchase.
Brand equity – This is made up of intangible assets such as a company's reputation and brand identity. A company's brand can create value through consistently effective marketing. A loyal customer base can also contribute to brand equity.
The difference between stocks and equity
While stocks and equity are sometimes used interchangeably, as an investor, it's a good idea to understand the difference between these terms. When a listing of shares takes place via an initial public offering (IPO) or new issue, a certain amount of equity, or ownership, is assigned for investors to purchase in the form of stocks. Post listing, these can be traded on stock exchanges. Simply put, stocks are market-traded shares of a company and are sometimes called 'equities'. This is not to be confused with 'equity' which refers to ownership in a company.
How is equity used by investors?
Equity is simply the value of an investor's stake in a company. It is represented by the value of shares an investor owns. Stock ownership gives shareholders access to potential capital gains and dividends. It may also give shareholders voting rights during the elections for the board of directors or other corporate activities.
Other terms like shareholders’ equity, book value, and net asset value are often used to describe equity. While the specific meanings of these terms may differ slightly, they are generally used to determine if the company receives funding from lenders or investors. In other words, it refers to the value of an investment that would be left over after paying off all the liabilities associated with that investment.
What is return on equity?
Let's say an investor owns a certain amount of stock in a company. The investor's Return on Equity (ROE) is the rate of return they receive on their shares. This is calculated as a ratio and can be used to measure the ability of a company to generate returns. Firms with higher ROEs are generally preferred by investors who may use it to compare stocks within the same sector. This is because profit levels can vary across different sectors.
ROE = Net Income/Shareholder's Equity
Net income over the last fiscal year, can be found on the company's income statement and shareholders' equity can be found on the balance sheet.
As an example, let us assume that a firm generates a profit of $100,000 and has 1000 shares held by stockholders with a valuation of $50 per share. The firm then has to pay interest worth $10,000 to its lenders, which is deducted from profits to get net income.
ROE = (100,000 – 10,000) / (1,000*50) = 1.8
This means that investors generated $1.8 for every dollar invested.
On a final note
Equity is often used in many ratios as part of fundamental analysis and as a benchmark when assessing the purchase price of a stock. Equity can be found on a firm's balance sheet and is an important data point that can help analysts assess a company's financial health.
As a concept, equity is of great importance to investors as it helps them to understand the value of their investments and to build long-term financial stability.
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