In the world of business and finance, equity refers to the value of ownership in something. Equity can be used to measure the value of an entire business, a single stock issued by a business, the inventory owned by the business, or any other thing that has value.
Here's why equity matters to business owners, investors, and even consumers choosing between products.
What Is Equity?
Equity measures the value of ownership. In other words, it's how much someone could get paid for selling something they own. The concept can be applied broadly to entire organizations, or it can be narrowly defined as the market value of an individual item. Companies will list their overall equity on their balance sheet, adding together retained earnings with the value of inventory and other assets, and then subtracting the liabilities like loan debt.
- Alternate definition: "Equity" may also be used to refer to the pursuit of justice, usually in the context of social issues like race or gender. This definition has no connection to equity as a measure of value, though both terms may be used in business settings. For example, a company could alter its recruitment policies in an effort to achieve greater racial equity during the hiring process.
While equity is perhaps most often used in the context of investing and analyzing balance sheets, it can be applied to any form of ownership. Another common use of equity applies to homeowners. Just like a business tallying up assets and subtracting liabilities, homeowners can measure their home equity by assessing the value of their property and subtracting any remaining balance on their mortgage.
How Does Equity Work?
As a financial term, equity always represents some type of business value, but it has multiple uses. In the following applications of the term, you'll notice that they all boil down to the same concept: equity is the sum of inventory, assets, and net earnings.
Equity can refer to the ownership interest in a company as represented by securities or stock. Investors can own equity shares in a firm in the form of common stock or preferred stock. Equity ownership in the firm means that the original business owner shares ownership with others, known as shareholders.
Each share's equity can be represented as the cash value they could receive for that share if they were to sell it. This value changes throughout the trading day as a result of market forces. An investor can assess their total equity stake in a company by multiplying the equity value of a single share by the total number of shares they own.
If someone owns stock in a company that's not publicly traded, it's called private equity.
If a trader engages in margin trading, which involves borrowing money to buy stocks, then that trader's equity is the value of securities in their account minus what has been borrowed from the brokerage.
On a company's balance sheet, total equity is represented by the sum of common stock, preferred stock, paid-in capital, and retained earnings. This is known as shareholders' equity, or stockholders' equity, because it represents the total equity shared by all of a company's owners.
When talking about real estate, equity is the difference between the fair market value of the property and the balance owed on the mortgage.
If your business goes bankrupt and you have to liquidate, ownership equity is the amount of money remaining after the business repays its creditors and sells all of its assets. Depending on a business's financial standing, there may not be any ownership equity after debts have been repaid.
Positive and Negative Equity Example
Consider these two simplified hypothetical scenarios.
Suppose Joe wants to sell his business, Joe's Excellent Computer Repair. He rents his workspace, but he does own $15,000 worth of equipment and accounts receivable from his customers. Joe took out loans to start the business, and he owes $5,000. For this example, Joe has $10,000 worth of equity in his business.
Now, imagine that Joe needed more loans to operate. If those loans total more than $15,000, then Joe would have negative equity. He could sell all of his assets and collect all of his accounts receivable, and he still wouldn't be able to cover his debts.
When calculating equity, the total value of assets will include both tangible and intangible assets. Tangible assets are physical possessions, like product inventory, facilities, and property; intangible assets include a company's reputation, intellectual property, and brand identity.
To better understand intangible equity, consider the difference between a brand-name product and a generic one. They should be largely the same product, but the generic version usually costs less. That's because the brand-name product has an intangible value from being tied to a well-known brand.
Intangible equity is built up through years of being in business and successfully servicing your customer base. Therefore, large corporations that have served a larger region for decades are more likely to have intangible equity than a new startup business.
- Equity is the value an owner could receive in payment for selling something they own.
- Equity can be used to measure the value of a business, a stock, a home, or any other thing that has value and clear ownership.
- Equity takes debt and other liabilities into account, and equity can be negative when the debt tied to something outweighs that thing's value.
- Equity can also account for intangible assets, such as reputation or brand identity.