What Is Equity?

Equity is the value of an investor’s ownership of an asset. The concept of equity is most commonly applied to two types of assets: a shareholder’s equity in a company or a homeowner’s equity in their property. Less commonly, the term equity is also applied to intangible assets, such as the brand equity of a company.

Equity is calculated by taking the total value of assets and subtracting the debt associated with them.

For example, a homeowner’s equity is the total value of their property (how much they can expect to sell their house for), minus the outstanding debt on this asset (how much of the mortgage they still owe to their lender).

A similar concept also applies in business. If a company holds $1 million in assets but has $500,000 in debt, the total equity of the firm is $500,000. Each shareholder in the firm technically owns a portion of this equity corresponding to how many shares they hold.

The equity of a company can be found on its balance sheet, which details assets and outstanding debts. This type of equity is a key piece of information that is used to assess the financial health of a company.

How shareholder equity works

In principle, a shareholder’s equity is the amount of money that would be returned to them if a company liquidated all of its assets and paid off all its debts.

Companies rarely go through total liquidation while in a positive equity position, and so it’s rare that a shareholder is ever paid the total value of their equity. Still, shareholder equity is an important investing concept as it’s a straightforward measure of a company’s financial health.

A company that owns many valuable assets may appear to be a good investment opportunity, but if it also has significant debts, it may be less robust than it at first appears.

Owning equity in a firm gives shareholders the potential for capital gains and dividends: that is, a return on their investment. Secondly, owning equity often affords shareholders the right to vote on corporate actions and in elections to the board of directors. This gives them a say in the way that a company is run.

Shareholder equity can be positive or negative. If the value of the total assets held by a company is greater than its outstanding debts, shareholder equity is positive. If its debts are greater than the value of its assets, shareholder equity is negative. A company with negative equity is commonly regarded as a risky investment, and if a company has negative equity for a long time it may be considered “balance sheet insolvent” because it won’t be able to pay investors back if it fails.

Equity vs. return on equity (ROE)

Return on equity (ROE), a concept derived from shareholder equity, is calculated by taking the income of a company and dividing it by shareholder equity. Return on equity is often used by investors as a measure of a company’s financial performance.

More precisely, the ROE of a given company indicates how efficient it is in generating profits from shareholders’ investments.

How to calculate shareholder equity

Calculating shareholders’ equity in a company is relatively straightforward because it only takes into account two key figures that appear on a firm’s annual balance sheet: a company’s total assets and its total liabilities.

Shareholders’ equity can then be calculated using this formula:

Shareholders' Equity = Total Assets - Total Liabilities

Home equity

Another type of equity is home equity. Homeowners are familiar with this type because it represents the value of the portion of their home that they own.

Just as with shareholders’ equity, home equity is calculated by taking the total value of an asset (in this case, real estate), and subtracting the value of outstanding debts that are associated with it (commonly, a mortgage). In order to calculate home equity, you take the fair market value of your home — that is, the amount of money you would expect to sell it for — and subtract the total amount you still owe.

When calculating equity, it’s important to differentiate this from the amount you’ve so far paid for your home. While your payments form part of your equity, so does home appreciation, the potential increase in price due to demand, inflation and other factors.

Home equity is often an individual’s greatest source of collateral, and the owner can use it to get a home equity loan (which some call a second mortgage) or a home equity line of credit (HELOC).

Private equity

In contrast to equity in publicly traded companies, private equity refers to ownership stakes in private corporations. Private equity companies buy businesses on behalf of investors and try to grow their values.

Privately held companies can still sell shares, but they don’t do so on the open market. Instead, they seek investors by selling off shares directly in what are called private placements. These private equity investors can include institutions like pension funds, university endowments, insurance companies or accredited individuals.

It’s uncommon for the average investor to have access to private equity. Only “accredited investors” with a high net worth can generally invest in this way. However, in recent years we’ve seen the development of private equity exchange-traded funds (ETFs), which allow smaller-scale investors to gain some exposure to the private equity market.

Brand equity

The concept of equity can also be applied to assets that are intangible. This is a more recent use of the term and can be more complex to calculate than shareholder or home equity.
The central idea of brand equity is that by building up brand recognition or a loyal customer base, a company’s brand can have value in itself. This is only loosely related to the tangible assets that a company owns.

For example, Coca-Cola is an internationally recognized brand and has many loyal customers. A can of Coke, however, may cost more than a comparable can of generic cola. If a bottle of Coca-Cola costs $2 and a comparable generic cola sells for $1, Coca-Cola is said to have $1 of “brand equity.” This can then be scaled according to the value of the cola market.

It can be difficult to assess a company’s brand equity because this relies on a subjective assessment of the power of a company’s brand in driving purchasing decisions. However, brand recognition, and therefore brand equity, can be important factors for investors to consider.

Equity key takeaways

• The term equity is commonly used in several different circumstances, but it always represents the difference between the value of assets and the debt associated with them.
• Home equity, for example, represents the difference between the value of real estate and the mortgage debt that a homeowner still has. Similarly, the equity of a company is the value of the assets owned by a company minus its debts – the amount of money that shareholders would receive if a company underwent total liquidation.
• Shareholder equity is used by investors as a key metric in assessing a company’s financial health, and therefore whether shares in the company represent a wise investment.