Equity: everything you need to know
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Equity is a term often found on a company’s balance sheet, but it’s also a common term used amongst investors and in accounting, as well as in personal finances. On this page, you’ll find out more about what equity is, why it’s important to understand it and what the different forms of equity are.
Equity basics: Equity represents the value or amount of money that would be returned to a company’s shareholders if all assets were liquidated (sold to convert into cash) and all debts paid
Useful measure: Equity helps identify the value of an investor’s stake in a company that represents the shares they own
Types of equity: Owning equity in certain companies can give you the right to vote on company actions and the election of board directors as a shareholder, whilst you can also hold equity personally, such as through the value of your home
What is equity?
Equity is defined as the amount of money that could be returned to a company’s shareholders once all the assets are liquidated, and all company debt is paid off. Equity belongs to each shareholder in a publicly listed company, or the owner(s) if the company is private.
Shareholder equity can also represent the book value of a company, which is calculated as the difference between assets and liabilities on a company’s balance sheet. The use of shareholder equity often occurs in accounting, and the balance sheet equation is as follows:
Liabilities + equity = assets
To work out the equity of an entity, you can rearrange the formula above to
equity = assets – liabilities.
This data is commonly used by analysts to determine the financial state or the health of a company.
Why is equity important?
Equity is important because it provides a good overview of the financial health of a company, and can be used to generate funds and investments into the company for achieving growth and expansion. Equity is sold in the form of shares to investors, who in turn generate income for the company.
Shareholder equity can be negative or positive. If the equity is positive, this means that the company has enough assets to cover its liabilities. Conversely, if a company’s equity is negative, its liabilities exceed its assets.
A shareholder’s equity can help determine the health of a company, and when used alongside other tools, investors can accurately analyse an organisation’s financial wellbeing.
How do you calculate a company's equity?
Company equity determines a company’s net worth, and is calculated as the amount of money that could be returned to a company’s shareholders once all the assets are liquidated and all company debt is paid off. Equity belongs to each shareholder in a publicly listed company, or the owner(s) /investors if the company is private.
What are the different forms of equity?
Equity doesn’t only evaluate a company’s health. In more general terms, equity is the degree of ownership found in any asset, either in a company or personally, after deducting all debts. The following are variations of company equity:
- Any stock or other securities that represent ownership in a private company are called private equity.
- On all company balance sheets, the number of funds contributed by shareholders, including earnings or losses, may also be called a stockholders’ equity.
- When it comes to margin trading, or borrowing money from a broker to trade an asset, the value of securities in a margin account minus what the account holder borrowed from the brokerage, is equity.
- When a business is declared bankrupt and goes into liquidation, its equity is the amount of money remaining after the business pays back its debts to its creditors. This type of equity is known as ownership equity or liable capital.
Private equity
Publicly traded investments show the market value of equity as seen through the company’s share price and its market capitalisation. However, for private entities, this market mechanism doesn’t exist, meaning they must use other forms of valuation to determine their value.
Private equity refers to the wealth of companies that don’t trade publicly. The same accounting equation applies in private equity, which is: value – liabilities = equity.
Privately-held companies can seek investors by selling their shares to private equity funds. These private equity investors can include institutions such as pension funds, university endowments and insurance companies.
Private equity is also often sold to funds and investors who specialise in direct investments or those that engage in leveraged buyouts of public companies. Leveraged buyout transactions occur when a private equity company receives a loan from one or more banks or other investors to fund the acquisition of another company. Cash flow or company assets of the target company can be used to secure the loan.
Private equity can come at different points in a company’s life. In most cases, young companies with no revenue or earnings won’t be able to afford to take out a loan and scale their business. For this reason, these companies usually get their capital from friends, family, or business people, known as angel investors.
Venture capitalists receive a minority stake in the business at an early stage, in exchange for providing private equity finance. They usually invest when a company has created a product or service that’s ready to be brought to the market. They may take a seat on the board of directors to ensure they have an active role when it comes to company growth.
Home equity
Home equity, or property equity, is the value of the interest you own on your home. Suppose you take the market value of a property and deduct any borrowed money attached to it, such as an outstanding mortgage amount. In that case, the leftover portion is the equity you own.
The amount of equity you own in your home fluctuates over time, based on mortgage repayments and any market forces that might impact the value of the property. For example, the deposit you put down entitles you to some equity in the house, which increases as you pay off your mortgage.
You can have both positive and negative equity in a property. Positive equity is a good thing, as it means your house is worth more than your mortgage, with negative equity being the opposite (more on negative equity shortly).
For example, say the market value of your house is £250,000, and you bought the house with a £30,000 deposit and got a mortgage for the remaining £220,000. This means the property is worth more than your mortgage debt, giving you positive equity.
You can also see positive equity as a good long-term strategy to build wealth. By gradually making mortgage repayments, you are increasing your share of equity in the property. The following table takes a quick look at the pros and cons of positive equity.
Pros and cons of positive equity
Pros
- By increasing the equity you own in your home, you can one day own it outright, which will rapidly reduce your monthly outgoings in later life whilst ensuring you have somewhere to live.
- Owning your home outright also means you will be able to leave any children or dependents a form of inheritance.
- If you wish to access some cash while keeping your home, you can do so in the form of an equity release, which essentially releases you from a portion of ownership in exchange for cash. You should only take this option after much consideration and independent financial advice.
- If you decide to sell your house while you’re in positive equity, you stand to make a profit after paying off your mortgage.
Cons
- Positive equity is a long-term goal that doesn’t guarantee instant wealth.
Negative equity, on the other hand, happens when the value of your property is less than the mortgage secured on it, something which is usually caused by falling house prices and more commonly experienced by those with interest-only mortgages.
For example, say you bought your property for £250,000, using a £30,000 deposit and taking out a £220,000 mortgage. Since then, the value of your property has decreased to £200,000. As this is £20,000 less than your mortgage, it places you in negative equity.
The main threat posed by negative equity is that you might find it difficult to sell your home. You may be able to move and transfer your negative equity over with you if you can find a negative equity mortgage, but these types of mortgages tend to be quite rare and not a lot of lenders offer them. Securing a negative equity mortgage will also be dependent on the following factors:
- How much negative equity you have
- The value of the property you wish to move to
- If you are up to date with your existing mortgage
- How much deposit you’re able to raise for the new property
The table below considers the pros and cons of negative equity:
Pros and cons of negative equity
Pros
- You can move house without having to pay off the negative equity on your mortgage, which is useful in an urgent situation such as moving for work or relocating for your family's needs. You will, however, need to find a negative equity mortgage to make this happen.
Cons
- You might be required to pay early repayment charges on your existing mortgage.
- There may be extra fees & charges as well as a higher rate of interest on your new mortgage.
- Very few lenders offer negative equity mortgages.
Brand equity
Brand equity typically measures the perceived value of a brand, or its social value, often from a consumer point of view.
A corporation’s equity can also include tangible assets, such as property, as well as intangible assets, such as a company’s reputation and brand identity.
Negative brand equity also exists and is exemplified when you would be willing to pay more for a generic or store-brand product than you would for a well-known brand name. Negative brand equity is rare and usually occurs because of bad publicity, such as product recalls or a public relations crisis.