Equity: What is Equity in Finance?

Equity


What does Equity mean?

Equity is the value attributable to the owner of a business. It’s a combination of owner’s equity & liabilities. It is also called as shareholder’s equity/Owner’s equity/Stockholder’s equity or a net worth.

Owner’s equity = Assets - Liabilities

For example – Suppose the cost of your home is £300,000 & you have mortgage of £100,000
Equity = Assets – Liabilities
Equity = £300,000 - £100,000 = £200,000

There are two types of equity -

  1. Book value – Book value is calculated as the difference between assets & liabilities on the company’s balance sheet.

  2. Market value – The market value of equity depends upon the current price of the share or value determined by investors.

Equity

Book Value of Equity

The equity is always listed at its book value. The book value of the equity is determined by accountants after preparing the financial statements. The balance sheet consists of two sides and forms the equation - Assets = Liabilities + Equity but it is rearranged as equity = Assets – Liabilities, when we calculate the book value of equity.

The sum of each current & non-current asset on the balance sheet forms the value of company’s assets. Current & non-current assets include cash, inventory, accounts receivable, fixed assets such as building, machinery, intellectual property, plant & equipment and intangible assets like goodwill, trademark, copyright etc.

The sum of each current & non-current liability on the balance sheet forms the value of company’s liabilities. Current & non-current liabilities include accounts payable, deferred revenue, short term & long term debt, capital leases and any fixed financial commitment.

Book value = Assets – Liabilities

The value of equity can be calculated in much more detail. It is a function of the following accounts –

  1. Share capital

  2. Retained earnings

  3. Contributed surplus

  4. Dividends

  5. Net income or loss

Book value = Share capital + Retained earnings

Market Value of Equity

Market value of equity depends upon the current price of the share or the value determined by the investors. Market value of equity may be materially higher or lower than the book value. Market value of equity is calculated to make an estimate about future and to know the financial performance of the company. As you know, accounting statements are backward looking and we want to know the current performance of the company. Therefore, it is necessary to calculate the current market value of equity. It is very easy to calculate the market value of equity.

Market value of equity = Share price x number of shares outstanding.

You can also calculate the market value of equity by estimating it via DCF analysis.

In case of private companies, it is difficult to determine the market value of equity. If the company needs to be formally valued, investment bankers, accounting firms or boutique valuation firms are hired to perform a detailed analysis.

Estimating Market Value of Equity

The market value of equity can be estimated in case of private companies. Professionals are hired to estimate the market value of equity. In order to estimate the market value of equity, two different professionals can arrive at two different values for the same business. The most used methods to estimate the market value of equity are –

  1. Discounted cash flow analysis (DCF Analysis)

  2. Comparable company analysis

  3. Precedent transactions

Personal Equity (Net Worth)

Personal equity means the personal net worth of an individual. Personal net worth is calculated by subtracting the personal liabilities from the personal assets acquired by an individual.

Personal net worth = All personal assets – All personal liabilities

Some examples of personal assets are as follows -

  1. Cash

  2. Furniture & household items

  3. Cars & other vehicles

  4. Investments

  5. Real estate

Some examples of personal liabilities are as follows –

  1. Outstanding loans (Electricity, water, gas, phone)

  2. Student loans

  3. Mortgages

  4. Credit card debt

  5. Lines of credit

Why should I invest in Shares?

Investment in shares is one of the most profitable businesses now a days but it can lead to higher losses too. Shares are issued by companies to raise money through investors. When the shares are allotted to an individual, the person becomes the shareholder of the company. If market value of company goes up, Shareholders receive profits in the form of dividend paid by the company but if it goes down, investor can suffer huge losses too. After purchasing the shares and becoming the shareholder or part owner of the company, you are eligible for few perks as well as discounts on Company’s products & services. This depends upon the performance of the company.

Different Types of Shares

There are two types of shares –

Ordinary Shares

Buying ordinary shares will makes you a part-owner of the company. After purchasing ordinary shares, you are eligible for the dividends paid by the company from its profit after meeting all its other obligations.

Companies may pay certain percentage as dividend from its profits to their shareholders but it is not mandatory that they have to pay dividend to the shareholders every time. If company is rising and earning huge profits, Dividends are paid by the company to the shareholders as a token of happiness. The decision of paying dividend to the shareholder fully depends upon the owner.

Preference Shares

Preference shares are those shares which carry certain special or priority rights. It does not carry any voting rights and dividend at a fixed rate is payable on these shares before paying the same on equity shares. Preference shares are less risky as well as payouts are also lower as compared to ordinary shares.

What are Equity Funds?

If you want to invest directly in shares, it can be a risk as returns on your investment depends upon the performance of a company. It is always suggested that you buy equities through an investment fund (Unit trust or open ended investment company, investment trust or exchange traded fund). Buying shares through them will diversify your investment as they invest in a range of shares and in different companies. There are different types of equity funds each with their own features & level of risk. Equity funds are divided into following categories –

  1. Developed markets – Economically developed & less risky markets are known as developed markets. If you want to invest in the developed market, the risk will be low but it doesn’t mean that it is risk free. It is to be noted that some companies listed in developed markets may not do business in that country and doing business in the emerging markets. They choose the developed markets to list on one of the world’s leading stock exchanges. Some of the examples of developed nations are given below –
    a) UK
    b) North America
    c) Europe
    d) Japan

  2. Emerging markets – Less developed and moderate risk markets are known as emerging markets. In these markets, situation changes rapidly and you may earn high profits or lose your money too. These markets are having great potential to grow as their economies grow. Some examples of emerging markets are –
    a) BRIC
    b) Asia pacific
    c) MENA

  3. Company size – Some of the funds are invested according to market capitalization. As per size, company is divided into three caps –
    a) Large Cap – A large cap company pays regular dividends to their investors as well as offers the potential for steady growth in the share prices. They are having the net worth of £10 billion.
    b) Mid cap – Mid cap companies are slightly risky as compared to large cap companies. They are having great potential for growth and are still in the position to pay dividends to their investors.
    c) Small Cap – Small cap companies contains high risk, don’t pay dividends generally to the shareholders but their share prices can go high, if they become successful.

  4. Industry – In this case, Funds are invested in particular industries such as finance, marketing, technology, mining, pharmaceuticals, energy etc.

How to make money in Equities?

Investors can make money from equity by the following ways –

  1. Dividend – Dividend is the amount paid to shareholders from the profits earned by the company. It is usually paid twice a year. Individuals invest their money more in long-established companies as these companies are having more chances to earn profits and more profits results in high dividend payout. Small companies don’t usually pay dividends and try to grow their business more by reinvesting their profits.

  2. Capital growth – Capital growth is earning profits on the basis of increase and decrease in share price. If share price goes up, it will result in profits and provides you capital growth.

Do I Pay Tax on Shares?

Yes, you have to pay taxes on the dividends but investors receive £2000 as dividend allowance. It means that the first £2000 of dividend income is tax free. After this, Dividends are taxed at 7.5% in the case of basic rate tax payers, 32.5% in the case of high-rate tax payers & 38.1% in case of additional rate tax payers.

When you sell your shares, you may be liable to pay capital gains tax on any gain exceeding £11700 for tax year 2018-19.

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