Equity represents the amount of money that would be returned to a company’s shareholders if that company were to liquefy its assets, pay off its debts, and distribute the remainder of its capital. More generally, equity can be thought of as a degree of ownership of an asset after subtracting all debts associated with it.
Equity is recorded on a company’s balance sheet along with assets and liabilities.
To determine a company’s equity, just take the sum of their assets and subtract the sum of their liabilities.
The primary way a company increases its equity is by selling shares of the company on the stock market.
Companies sell securities as a way to raise capital to further finance business operations, aside from the income made from regular business operations.
Shareholders also sometimes earn a profit through dividends.
Companies that make a particularly large income, such that they have no reasonable way to use all of their income to expand business, may choose to distribute a portion of leftover cash to its shareholders as dividends.
The amount of equity a company has left after paying its investors dividends is known as retained earnings.
Retained earnings is an important figure for investors, especially long-term investors, since it effectively represents a company’s savings.
It’s the cumulative total of a business’s profits that have been put aside to use later.
Retained earnings counts directly towards equity; the larger a company’s retained earnings, the more money will be returned to investors in the event of bankruptcy; and in the event that the company does not go bankrupt, more retained earnings allow the business a larger safety net if they run into trouble.
The second way a company can increase its equity is by expanding its assets and/or reducing its liabilities.
Since equity is equal to a company’s assets minus its liabilities, increasing the former or decreasing the latter both cause a company’s equity to go up.
Investor Pro Tip: Return on Equity (ROE)
Return on Equity is a metric used to estimate how efficiently a company is able to generate profits with the assets and equity they have.
It is calculated by dividing a company’s net income by their total equity. Net income is determined by taking a business’s revenue and subtracting expenses, interest, and taxes to arrive at the amount of profit a company managed to generate from doing business.
Since equity is equal to the absolute value of a company’s assets, ROE is considered to be a measure of how effectively a company is using its assets to generate profit.
For example, let’s say that two competing shops both earned a net income of $10 million this year, but Company A has $50 million in equity, and Company B has $20 million.
Company A’s ROE is 20%, whereas Company B’s is 50%. Put another way, Company B managed to earn the same income as Company A with less equity to start with.
This indicates that Company B is using its assets more efficiently than Company A, and is likely the better investment.