What is equity?
Searching for an equity definitionis understandable in today’s world, especially when the word ‘equity’ can have so many different meanings when applied to different situations. In short however, equity means ownership, essentially referring to how much of something you actually own, taking away any outstanding charges due or any money that was borrowed to buy it. The following accounting equation represents equity: Assets – Liability = Equity.
Where have you heard about equity?
If you’ve ever made an investment, you will have likely come across the term ‘equity’. In this context, ‘equity’ refers to stocks and shares - one of the main asset classes of an investment portfolio.
Equity is also regularly used to state how much of a property a person owns, with home equity specifically referring to the market value less the mortgage balance. If a homeowner has outstanding mortgage payments, they do not fully own the property but will have full equity once the mortgage has been paid off.
Likewise, for a car investment – if a car owner has no outstanding debt payments to make, the car would be considered entirely the owner’s equity and the owner would be able to sell the car at their own convenience and pocket the cash.
What you need to know about equity…
As mentioned above, equity can refer to a number of different financial scenarios including property and stocks and shares. In an investment strategy, equity is one of the principle asset classes along with bonds and cash/cash equivalents. If a company was to go bankrupt, any remaining money once the company has paid its creditors is often referred to as ownership equity or risk capital or liable capital.
When calculating equity, it is important to identify the value of the good, land, inventory or earnings as well as any liabilities including debts and overheads. Calculating equity then becomes a question of taking away any liabilities from the total value. To put this in an example, a homeowner called Bob has a property estimated to be worth £100,000 and an outstanding mortgage of £40,000. However, when Bob bought the property, it was valued and sold for £80,000. In this scenario, the amount of equity Bob holds is £60,000 (£100,000 current market value less £40,000 debt obligations) or 60% (£60,000/£100,000). These figures would change slightly in the hypothetical scenario that Bob was to take out an equity loan (more on this below).
Calculating equity in a property can also be expressed through the loan-to-value (or LTV) formula, which takes the remaining loan balance and divides it by the present market value and presents as a percentage. The higher the LTV, the less likely it is that a lender will issue another loan. It is important to state at this point that home equity is subject to fluctuate depending on the market value – for example, when the financial crisis of 2007/2008 happened, house prices plummeted causing millions of pounds’ worth of home equity to be completely wiped out.
In the UK, an equity loan is a term used to describe additional borrowing on top of the amount a homeowner has already borrowed from the main mortgage provider. This loan is usually used by the government to help out buyers who would otherwise struggle to buy a property with only a conventional mortgage, and also by builders to encourage house sales. In other parts of the world, an equity loan can be taken out on a home without a mortgage in which the borrower then receives the loan in cash. For example, if an individual with full ownership of a property worth £100,000 takes out an equity loanof a 50% loan-to-value, the individual would then receive £50,000 in exchange for a mortgage on the property.
As an investor, one important point to be aware of is the impact that margin trading can have on your equity. If you trade on margin, then your equity is the value of the securities in your margin account minus what has been borrowed from the brokerage. Our margin trading guide explains this in greater detail, so take a look if that applies to you.
When an individual has equity in a company, it is in their interest that the company does well so that the value of their equity goes up (with the value of the equity determining the company’s share price). If a business wishes to raise capital, they may decide to sell shares in a process called equity financing. In equity financing, the sale of ownership to raise funds is for business purposes with the scale and scope varying massively. Equity financing is a term usually reserved by public companies listed on an exchange, but private companies also use the process regularly.
In equity financing, common stock (a security representing ownership in a corporation) is generally sold, but some situations also include the selling of other equity – for example, preferred stock. In exchange for cash as a result of the sale of company stock, shareholders then receive a portion of ownership of the company. Early-stage equity financing often involves an outside investor such as a venture capitalist or angel investor. Any funds raised by a business from equity is referred to as paid-in capital.
Though equity generally refers to tangible assets, it can also refer to intangible efforts such as a company’s reputation and brand identity. Equity in this example is often referred to as brand equity – for example, a supermarket may stock both tins of Heinz beans costing 80p and their own brand of beans costing 40p. In this example, Heinz would have a brand equity of 40p. Though uncommon, brand equity can also be negative – an example of this would be a customer opting for a generic store product over a big-name brand as a result of bad publicity surrounding the brand. A specific example of this would be a customer deliberately snubbing a clothing label that is known to use real fur in their designs, preferring instead to buy from another brand that they know uses ethical production techniques.
As touched on briefly, equity is one of the key components of a balance sheet with equity at balance sheet stated alongside the company’s assets and liabilities. Equity at balance sheet can refer to common stock; retained earnings; capital in excess of par value and accumulated other comprehensive income (loss). In addition, equity at balance sheet also refers to shares (including authorised, issued, fully paid and partially paid); reconciliation of shares outstanding; treasury shares; a description of share rights, preferences and restrictions; shares reserved for issuance under options and contracts; and a description of the owner’s equity’s nature and purpose. Stocks in a private company are referred to as private equity with the company’s balance sheet listing this investment as stockholders’ equity, or shareholders’ equity.
Stockholders’ equity and shareholders’ equity go hand in hand, representing the equity stake held on the books by a company’s investors and shareholders. Shareholders’ equity is calculated by subtracting the company’s total liabilities from its total assets, with the result listed on the company’s balance sheet. Stockholders’ equity derives from either initial money invested in the company or retained earnings that the company has built on over time, with the figure growing larger as the company reinvests more of its own income.
Treasury shares on the other hand, represent stock that the company has purchased back from its shareholders. These shares can be reissued back to shareholders in the event that the company needs to raise capital. Stockholders’ equity is one of the most popular financial metrics used to determine a company’s financial health, with many seeing stockholders’ equity as a representation of the company’s net assets or net value.
Find out more about equity…
Our online glossary has a wealth of definitions relating to equity including balance sheet, shareholder and equity risk. Homeowners looking to work out how much equity is in their house may also find the equity calculator on Money.co.uk useful.