Equity (finance)

For other uses, see Equity.

For equity securities, see Stock.

In accounting, equity (or owner's equity) is the difference between the value of the assets and the value of the liabilities of something owned. It is governed by the following equation:

${\text{equity}}={\text{assets value}}-{\text{liabilities}}$

For example, if someone owns a car worth $15,000 (an asset), but owes $5,000 on a loan against that car (a liability), then they have $10,000 of equity in the car. Equity can be negative if liabilities exceed assets, in which case it is called a deficit.

Shareholders' equity in a firm (also called stockholders' equity, shareholders' funds, shareholders' capital or similar terms) is the part of equity that is eligible to be distributed to shareholders in a liquidation. Equity and shareholders' equity in a firm are calculated from its history of stock transactions and net results. They can be, and often are different from the market value of the firm's stock, which also reflects expectations about its future prospects. Despite this difference, equity is often used as a synonym for stock outside of accounting.

In government and non-profit organizations other terms may replace equity, including "capital" and "net position."

Accounting

Equity appears on the balance sheet (also known as the statement of financial position), one of the four primary financial statements.

Subaccounts

The types of accounts and their description that comprise the owner's equity depend on the nature of the entity and may include:

• Share capital (capital stock)
• Preferred stock
• Capital surplus (additional paid-in capital)
• Retained earnings
• Treasury stock
• Stock options
• Reserves

Another financial statement, the statement of changes in equity, details the changes in these subaccounts from one accounting period to the next.

Changes in equity

Several events can produce changes in a firm's equity.

• Stock issues: An issue of new stock increases base capital and capital surplus by the amount paid for the stock.
• Accumulation: Income or losses may be accumulated in an equity account called "retained earnings" or "accumulated deficit," depending on its net balance.
• Stock repurchases: When the firm purchases shares into its own treasury, the value of the stock appears as contra-equity — an offset to equity — since it no longer belongs to the owners.
• Unrealized investment results: Changes in the value of securities that the firm owns, or in foreign currency holdings, are accumulated in its equity.
• Liquidation: A firm that liquidates with positive shareholder equity can distribute it to owners in one or several cash payments.

Classes of equity

When the owners are shareholders, the interest can be called shareholders' equity; the accounting remains the same, and it is ownership equity spread out among shareholders. If all shareholders are in one and the same class, they share equally in ownership equity from all perspectives. However, shareholders may allow different priority ranking among themselves by the use of share classes and options. This complicates analysis for both stock valuation and accounting.

Investing

Equity investing is the business of purchasing stock in companies, either directly or from another investor, on the expectation that the stock will earn dividends or can be resold with a capital gain. Equity holders typically receive voting rights, meaning that they can vote on candidates for the board of directors and, if their interest is large enough, influence management decisions.

Principles

Investors in a newly established firm must contribute an initial amount of capital to it so that it can begin to transact business. This contributed amount represents the owners' equity interest in the firm. In return, the investors receive shares of the company's stock. Under the model of a private limited company, the firm may keep contributed capital as long as it remains in business. If it liquidates, whether through the decision of the stockholders or through a bankruptcy process, the stockholders have a residual claim on the firm's eventual equity. If the equity is negative (a deficit) then the owners' claim is void. Under limited liability, owners are not required to pay the firm's debts themselves so long as the firm's books are in order and it has not committed fraud.

Stock valuation

Further information: Business valuation

A company's shareholder equity balance does not determine the price at which investors can sell its stock. Other relevant factors include the prospects and risks of its business, its access to necessary credit, and the difficulty of locating a buyer. According to the theory of intrinsic value, it is profitable to buy a stock when it is priced below the present value of the portion of its expected future earnings that will be available to its owners. Advocates of this method have included Benjamin Graham, Philip Fisher and Warren Buffett. An equity investment will never have a negative market value (i.e. become a liability) even if the firm has a shareholder deficit, because the deficit is not the owners' responsibility.

According to the "Merton model," the value of stock equity is modeled as a call option on the value of the whole company (including the liabilities), struck at the nominal value of the liabilities. This is the first example of a "structural model", where bankruptcy is modeled using a microeconomic model of the firm's capital structure - it treats bankruptcy as a continuous probability of default, where, on the random occurrence of default, the stock price of the defaulting company is assumed to go to zero.

Equity in real estate

The notion of equity as it relates to real estate derives from the concept called equity of redemption. This equity is a property right valued at the difference between the market value of the property and the amount of any mortgage or other encumbrance.

See also

• Art equity
• Private equity