DEFINITION of ‘Equity ‘
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BREAKING DOWN ‘Equity ‘
Generally speaking, the definition of equity can be represented with the accounting equation:
Equity = Assets – Liabilities
Yet, because of the variety of types of assets that exist, this simple definition can have somewhat different meanings when referring to different kinds of assets. The following are more specific definitions for the various forms of equity:
4. In the context of real estate, the difference between the current fair market value of the property and the amount the owner still owes on the mortgage. It is the amount that the owner would receive after selling a property and paying off the mortgage. Also referred to as “real property value.”
5. In terms of investment strategies, equity (stocks) is one of the principal asset classes. The other two are fixed-income (bonds) and cash/cash-equivalents. These are used in asset allocation planning to structure a desired risk and return profile for an investor’s portfolio.
6. When a business goes bankrupt and has to liquidate, the amount of money remaining (if any) after the business repays its creditors. This is most often called “ownership equity” but is also referred to as risk capital or “liable capital.”
The term’s meaning depends very much on the context. In finance in general, you can think of equity as one’s ownership in any asset after all debts associated with that asset are paid off. For example, a car or house with no outstanding debt is considered entirely the owner’s equity because he or she can readily sell the item for cash, with no debt standing between the owner and the sale. Stocks are equity because they represent ownership in a company, though ownership of shares in a publicly traded company generally does not come with accompanying liabilities.
Yet, in spite of what seems like substantial differences, these variants of equity all share the common thread that equity is the value of an asset after deducting the value of liabilities. One could determine the equity of a business by determining its value (factoring in any owned land, buildings, capital goods, inventory and earnings) and deducting liabilities (including debts and overhead).
Example of Deriving Equity
For example, suppose that Jeff owns and operates a factory that manufactures car parts and that he wants to determine the equity of his business. He estimates that the value of the property itself is $4 million, the total value of his factory equipment is $2 million, the current value of his inventory and supplies (processed and unprocessed) is $1 million and the value of his accounts receivable is $1 million. He also knows that he owes $1 million for loans he took out to finance the factory, that he owes his workers $500,000 in wages and that he owes his parts supplier $500,000 for parts he has already received. To calculate his business’s equity, Jeff would subtract his total liabilities from the total value of his business in the following way:
Total value – total liability = ($4M + $2M + $1M + $1M) – ($1M + $0.5M + $0.5M) = $8M – $2M = $6 million
Jeff’s manufacturing company, then, is worth $6 million. It is also possible for equity to be negative, which occurs when the value of an asset is less than the value of liabilities on that asset. The book value of a company’s equity may often change, and for a variety of reasons. Causes of change in equity include a shift in the value of assets relative to the value of liabilities, depreciation and share repurchasing.
Equity is important because it represents the real value of one’s stake in an investment. Investors who hold stock in a company are usually interested in their own personal equity in the company, represented by their shares. Yet, this kind of personal equity is a function of the total equity of the company itself, so a shareholder concerned for their own earnings will necessarily be concerned for the company itself. Owning stock in a company over time will ideally yield capital gains for the shareholder, and potentially dividends as well. It also often bestows upon the shareholder the right to vote in Board of Directors elections, and all of these benefits further promote a shareholder’s concern for the company, both through continued involvement and through personal gain.
Home equity is also very important, although for different reasons. Equity on a property or home stems from payments made against a mortgage (including a down payment) and from increases in the value of the property. The reason home equity is a concern for many is that it is often an individual’s greatest source of collateral, and thus can be used in financing for a home-equity loan (often called a “second mortgage”) or a home equity line of credit.
When attempting to determine the value of assets in calculating equity, particularly for larger corporations, it is important to note that these assets may include both tangible assets like property, as well as intangible assets, like the company’s reputation and brand identity. Through years of advertising and development of a customer base, a company’s brand itself can come to bear an inherent value. This concept is often referred to as “brand equity,” which measures the value of a brand relative to a generic or store brand version of a product. For example, many people will reach for a Coca-Cola (KO) or Pepsi (PEP) before buying a store brand cola because they are more familiar with the flavor or prefer it. If a 2-liter bottle of store brand cola costs $1 and a 2-liter bottle of Coca-Cola costs $2, then in this case coke has a brand equity of $1. Just as equity can be negative, so can brand equity, if people are willing to pay more for a generic or store brand product than for a particular brand. Negative brand equity is rare, and generally only occurs because of bad publicity, such as in the event of a product recall or disaster.