Equity is commonly used in several circumstances: home equity, shareholder equity, and brand equity. Generally, it is the value of assets held by a company or individual, minus the debt associated with them.
Equity is the value of an investor’s ownership of an asset. The concept of equity is most commonly applied to two types of assets: a shareholder’s equity in a corporation or a homeowner’s equity in his property. Less commonly, the term equity is also applied to intangible assets, such as the value of a company’s brand.
Equity is calculated by taking the total value of assets and subtracting the debt associated with them.
For example, a homeowner’s equity is the total value of his property (how much he can expect to sell his house for), minus the outstanding debt on this asset (how much mortgage he still owes to his lender).
A similar concept also applies in the business world. If a company has $1 million in assets but has $500,000 in debt, the company’s total net worth will be $500,000. Each shareholder of the company technically owns a portion of this capital corresponding to the number of shares he holds.
A company’s net worth can be found in its balance sheet, which details its outstanding assets and debts. This type of capital is a key piece of information used to evaluate the financial health of a company.
How share capital works
In principle, a shareholder’s net worth is the amount of money that would be returned to him or her if a company liquidated all of its assets and paid off all of its debts.
Companies rarely experience a total liquidation while in a positive equity position, and so it is rare for a shareholder to ever receive the full value of his or her equity. However, equity capital is an important investment concept as it is a simple measure of a company’s financial health.
A company that owns many valuable assets may seem like a good investment opportunity, but if it also has significant debt, it may be less solid than it appears at first glance.
Owning stock in a business offers shareholders the potential for capital gains and dividends: that is, a return on their investment. Second, owning stock often gives shareholders the right to vote on corporate actions and board of director elections. This gives them a say in how a company is run.
Shareholders’ equity can be positive or negative. If the value of the total assets held by a company is greater than the outstanding debts, the net worth is positive. If its debts are greater than the value of its assets, its net worth is negative. A company with negative net worth is commonly considered a risky investment and if a company has negative net worth for a long period it may be considered “balance sheet insolvent” because it will not be able to repay investors in the event of failure.
Equity vs Return on Equity (ROE)
Return on equity (ROE), a concept derived from shareholders’ equity, is calculated by taking a company’s income and dividing it by shareholders’ equity. Return on equity is often used by investors as a measure of a company’s financial performance.
More precisely, the ROE of a given company indicates how efficient it is in generating profits from shareholder investments.
How to calculate your net worth
Calculating a company’s net worth is relatively simple because it takes into account only two key figures that appear on a company’s annual balance sheet: a company’s total assets and total liabilities.
Net worth can then be calculated using this formula:
Net Worth = Total Assets – Total Liabilities
Home equity
Another type of equity is home equity. Homeowners are familiar with this type because it represents the value of the portion of the home they own.
Just as with equity, home equity is calculated by taking the total value of an asset (in this case, a property) and subtracting the value of any outstanding debts associated with it (commonly, a mortgage). To calculate your home value, take your home’s fair market value—the amount of money you would expect to sell it for—and subtract the total amount still owed.
When calculating your equity, it’s important to differentiate it from the amount you’ve paid for your home so far. While your payments are part of your equity, so is home appreciation, the potential increase in price due to demand, inflation and other factors.
Home equity is often an individual’s primary source of collateral, and the homeowner can use it to obtain a home equity loan (which some call a second mortgage) or a home equity line of credit (HELOC) .
Private equity
Unlike the equity capital of publicly traded companies, private equity refers to ownership stakes in private companies. Private equity firms buy assets on behalf of investors and try to grow their value.
Private companies can still sell shares, but they don’t do so on the open market. Instead, they seek investors by selling the shares directly in what are called private placements. These private equity investors can include institutions such as pension funds, university endowments, insurance companies, or accredited individuals.
It is rare for the average investor to have access to private equity. Typically only high net worth “accredited investors” can invest in this way. However, in recent years we have seen the development of private equity exchange-traded funds (ETFs), which allow small-scale investors to gain some exposure to the private equity market.
Brand equity
The concept of equity can also be applied to intangible assets. This is a newer use of the term and can be more complex to calculate than equity or real estate.
The central idea of brand equity is that by building brand recognition or a loyal customer base, a company’s brand can have value in itself. This is only loosely related to the tangible assets owned by a company.
For example, Coca-Cola is an internationally recognized brand and has many loyal customers. A can of Coca-Cola, however, can cost more than a comparable can of generic cola. If a bottle of Coca-Cola costs $2 and a comparable generic cola sells for $1, Coca-Cola is said to have $1 in “brand value.” This can then be scaled based on the market value of the cola.
It can be difficult to evaluate a company’s brand value because it is based on a subjective assessment of the power of a company’s brand in driving purchasing decisions. However, brand recognition, and therefore brand value, can be important factors for investors to consider.
Equity key points
- The term equity is commonly used in various circumstances, but it always represents the difference between the value of assets and the debt associated with them.
- Home value, for example, is the difference between the value of the property and the mortgage debt the homeowner still has. Similarly, a company’s equity is the value of the assets owned by a company minus its debts – the amount of money shareholders would receive if a company underwent a total liquidation.
- Share capital is used by investors as a key metric to evaluate a company’s financial health and therefore whether the company’s shares represent a wise investment.