What is equity?
Equity is a term with a variety of different meanings. One meaning (shareholder equity) is the value of an asset after all other liabilities and debts have been paid off. In the world of investing, equity is often used to mean a stock representing an ownership interest in a particular business.
Equity can also be used to refer to the degree of ownership someone has in something like a home or a car, as well as more nebulous concepts like brand equity (i.e. the extra value a brand’s name or reputation gives to its company).
Shareholder equity, while rudimentary, is considered a key indicator of a company’s financial performance. Essentially, shareholder equity is calculated by subtracting total liabilities from total assets. Equity can be seen as the base way of determining the health of a company: what it owns minus what it owes. In this sense, we can see shareholder equity as much the same as net assets.
Total Assets – Total Liabilities = Shareholder Equity
When equity refers to the stake an investor holds in a company, your personal equity in a company is the value of your stake, which you own as shares. Your personal equity may be valued simply as the current share price. However, other factors which can be factored into this equity include any dividend payments you receive and any input into the decision-making processes of the company.
Public equity vs private equity
The basic difference between public and private companies is their ownership structures. A private company will be owned by a small group of parties, usually those who founded or manage it, private investors or venture capitalists. Taking private equity in a company is generally the preserve of a small number of high-value, professional investors. However, private companies can issue a small amount of equity for public purchase without having to be on a stock exchange.
Public companies are “floated” on stock exchanges. This means they issue shares with the aim of raising capital. These can be bought by members of the public regardless of their investment experience, with the aim of raising capital. Share prices of public companies are publicly available and can fluctuate considerably and quickly (they are known as being liquid investments) because of a number of factors including financial performance and the wider economic environment. Private equity in public companies can, in some cases, be sold.
Equity is used by companies as a way of raising capital and is essentially the alternative to taking on debt (for instance in the form of loans or bonds). Companies may look to raise capital through a combination of equity financing and debt for a variety of reasons, including:
- Expansion of company (e.g. hiring new staff or opening a new office)
- Financing a large project
- Completing a takeover or merger
- Paying off debt
In terms of public equity, this is done by issuing shares. When a company makes the decision to “go public” they will usually do this by way of an Initial Public Offering (IPO). An IPO is just the issuance of the first batch of shares and confirmation of the company’s new status as public or “listed”. The capital raised will be used to fund operations with the aim (in theory) of raising the company’s value and the value of the shareholder’s equity.
Private companies use equity to raise capital in a slightly different way. They secure investment from larger, wealthier investment sources in exchange for giving away a minority stake in the business. Start-ups often use equity as a way of expanding and improving rapidly in their early years. Venture capitalist investors fund this expansion over relatively short time periods in exchange for equity.
Positive equity vs negative equity
The concept of positive and negative equity is relatively simple. In the case of a company or business, positive equity is when the total assets exceed (or at least cover) the liabilities and debt. Negative equity is therefore when the company’s liabilities and debts exceed its assets. Negative equity is indicative of an unhealthy state of financial affairs in a company and if it persists results in insolvency. Positive equity is usually an indicator of healthier financial performance but there are many other aspects of a company which determine whether it is in good shape.
The terms positive and negative equity are also used in the property sector. If a homeowner has positive equity in their house, it means its value is higher than the amount left to pay on the property’s mortgage. Negative equity means the value of the house is actually lower than the amount left outstanding on its mortgage. Positive and negative equity can be used around any item which was purchased with a loan. Positive equity is the norm for most houses bought with a mortgage as property is generally an appreciating asset, while negative equity is the norm for most cars bought on finance as the value of a car tends to drop quickly after purchase.