Equity is a term often used, but not everyone understands its significance. If you are starting a new business, startup, or undergoing a business valuation, equity or company equity sharing is a term you will hear often. Learn here about what equity is and what it means.
What Is Equity?
In financial terms, equity is the sum held by a company that it owes to the owners. The owners of a company are investors, promoters, shareholders, and others. A company receives money from owners, lenders, and shareholders. The sum owed to banks, financial institutions, and other creditors is a loan. The sum the company owes to equity shareholders is called equity.
So, a business’s equity is the amount left with it after paying off all the debts. The term is widely used in the business and finance world. It appears on the liability side of the balance sheet. Why? Because it is the sum that the company pays back to the shareholders on its liquidation or winding up. So, equity means ownership.
What Is Book Value and Market Value?
The book value and market value of equity differ. Book value refers to the price at which the company quoted an equity share during its initial issue.
Market value refers to the value a shareholder or trader is ready to pay to acquire the ownership. The market value of an equity shareholder depends on a company’s performance and reputation. Market value describes the desire of people to own that share and their confidence in the company.
Let’s take an example for a better understanding.
The company quoted its share at $10. But the company is reputed, and people are ready to pay more than $10 to own it. The share is trading in the market at $20. The premium of $10 above the book value portrays the shareholders’ confidence in the company’s earning capabilities.
How Is Equity Calculated?
It is easy to calculate equity. All the required data is available on the balance sheet. Deduct total liabilities from total assets; the figure arrived at is the shareholder’s equity.
Equity= Assets- Liabilities
Types Of Equity
Equity is further classified into various types.
Common Stock
The account classifies the equity shares initially issued by the company and records shares at face value.
The owner of common equity shares also gets certain rights, such as voting rights and having a say in the company’s affairs.
Preferred Stock
Preferred stock is different from common stock, as its name suggests. Preference shareholders get certain preferences over common stockholders. They have a right to the company’s assets before common stockholders are paid off and are also entitled to dividends. But they do not have voting rights.
Treasury Stock
Treasury stock is the account created to apportion the funds for purchasing stock from investors. It can be from the open market or promotors. Since market value differs from the book value, the treasury stock account usually carries a negative balance as the payment is always more than the face value.
Retained earnings
Retained earnings are also part of shareholder’s equity. It is the amount earned and accumulated by the company after setting off all the liabilities. It is the profit that the company keeps with it for future investment or expenses.
Additional Paid-In Capital
It is also called share premium and includes the amount investors pay above the par value. This amount can only be used for specified purposes but forms part of the shareholder’s equity.
Difference Between Business Valuation and Market Valuation
Business valuation is a process undertaken by professional business valuers who use different approaches to arrive at a figure which truly and correctly shows the worth of a company. It assists investors in decision making; how much they want to pay to get a part of the company’s stock to earn above the risk-free return.
The market valuation shows the market’s sentiments about a company. The figure can be arrived at by multiplying the current market price by the number of outstanding shares. It portrays what investors think is a company’s worth. For example, suppose a share with a face value of $10 is trading at $25. In that case, the investors believe they trust the company to pay back the excess amount in the future through dividends or other considerations.
Anyone can calculate the market value of a company without formal training or expertise, and no traditional methods are employed.
Conclusion
If you are undergoing business valuation, you must understand the nitty-gritty of the business and related terms. For example, equity holds great significance if you opt for equity financing or are a startup and finding investors. So, an understanding of equity is important; you must know what it means and why it is important. Hoping this guide has been helpful.
