There are many words that in the financial lexicon you probably understand in a general sense. But if you’re serious about investing, it helps to be specific about certain terms, one of which is ‘equity’. Knowing exactly what it is, and isn’t, is essential to any investment strategy. It doesn’t take long to solidify and expand a working definition of this market terminology essential. However, if you’re eager to learn how equity can play a role in your portfolio, a financial advisor can help you consider your options.
Individual and Corporate 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 value a company’s stock would return to its all its owners upon liquidation. Individual equity is simply a single investor’s share of ownership. But in either case, the formula is the same: Total company value, minus debts and liabilities, equals the cash value, or equity.
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. They wouldn’t actually owe any money to anyone. The negative equity reflects the amount of asset value the company would need to create before its investors could see a return.
What Are the Different Types of Corporate Equity?
The larger a company is, the likelier it will include three separate equity classes. In each case, the standard definition of equity-total value minus liabilities equals cash value-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 equity 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 an equity share, 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 this equity rises and falls with company performance, with each share’s price inflating or deflating depending on market activity.
Equity vs. 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 shareholder equity, 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.
Equity as Compensation
Many companies use equity as a form of compensation. Any employee is eligible, which Starbuck’s demonstrated when it offered equity 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. In extreme cases, masseuses can become instant millionaires, provided they’re lucky enough to be hired by the next Google and are wise enough to exercise their stock options.
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, 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 equity in the firm 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.
The Bottom Line
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
- 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.
- Determining the role stock equity plays in your investment strategy is easier when you have some professional guidance. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
Photo credit: ©iStock.com/fizkes, ©iStock.com/fizkes, ©iStock.com/ljubaphoto