In financial terms, equity means the value of something minus the amount that is owed on it. Thus, a house owner’s equity is the difference between the value of the house and the unpaid home loan. In popular understanding, equity represents a person’s or an entity’s ownership in a corporate body. In other words, owners of equity shares receive partial ownership of the company. Essentially, equity signifies the monetary value shareholders are entitled to receive when a company settles all debt and liquidates its assets.
Equity shares are popular investment vehicles. Equity investors can make a profit from the appreciation of stock prices or capital gains. Additionally, owning shares in a corporation grants individuals the right to vote on important matters related to the company.
This article will help you understand the basics of equity, the different types of equity shares, the financing methods, and how equity is valued. Read on to know more.
What is equity in finance?
Equity represents the funds that will be distributed to shareholders after the liquidation of a company’s assets and liabilities. In other words, it denotes the value and ownership stake held by an individual or business in an organization, calculated by deducting liabilities, including debt.
Equity investors are owners of the company in which they hold shares. As owners, they have voting rights in important decisions such as the appointment of directors and other corporate actions like mergers and acquisitions.
Equities are essential benchmarks financial analysts use to evaluate a company’s financial health. Familiarity with equity fundamentals helps businesses and professionals to gain insights about their investments and make informed decisions.
Types of equity
Equities are financial instruments that do not come with the assurance of a fixed interest rate. Returns on equity thus depend on the performance of the issuing organization.
Various types of equity accounts combine to form the total shareholders’ equity. Let’s understand the different types of equity:
- Common Equity
Common stock or equity is the ticket to ownership in a company. It represents the investor’s claim to the company’s assets and earnings. In case of bankruptcy or liquidation, common equity shareholders have the claim residual balance once the debt, bondholders, and preferred shareholders are paid off.
- Preferred Equity
Preferred equity is a distinct class of equity that comes with different rights compared to common equity. While both types confer ownership in a company, preferred shareholders have a higher claim to the company’s assets and dividends than common shareholders. This elevated status is reflected in the term “preferred” stock.
- Private Equity
Private equity refers to investment in firms not publicly traded or listed on a stock exchange. The private equity industry comprises institutional investors such as pension funds and large private equity firms funded by accredited investors. A significant capital outlay is needed because private equity invests directly in firms, often to gain influence or control over a company’s operations. Hence, deep-pocket funds and high-networth individuals (HNIs) dominate the PE industry.
- Public Equity
Initial Public Offering, or IPO is how a company offers its shares to the general public, representing a transition from private equity to public equity. Public equity refers to shares listed and traded on stock exchanges. One of the biggest advantages of public equity is its liquidity as most publicly traded stocks are available and can be easily traded on stock exchanges.
Equity in business
Business equity is the value of shares that a company has issued to its shareholders. As corporates need capital to run and grow their business, they often require shareholders to invest funds in their organization.
Shareholders have ownership rights in the company in which they hold equity. Shareholders will have voting rights and in the event of dissolution of the firm, they will have the last claim over the company’s assets after the loans and the bondholders are paid off.
Equity investments
Investors buy equity expecting to get returns that beat inflation to help them grow their wealth. The investment cycle works somewhat like this: Equity investment requires the investor to allot a certain amount of capital. During the tenure of the investment, the investor gets small capital inflows in the form of dividends. Ideally, when an investor exits the investment, the capital inflow should be large enough to beat inflation, leading to capital appreciation for the investor.
The higher the risk, the higher the return. This is as true for equity as it is for any financial instrument. While people invest in equity to get returns that are higher than those from fixed deposits and debt, it also means that the risk associated with equity will be theoretically higher.
The risks associated with equity investment are:
Systemic Risk
Systemic risk, also known as market risk, will impact all stocks in one way or another. System risk consists of:
- Interest rate risk
- Inflation risk
- Market risk.
These are the kinds of risks that will impact the entire market and are difficult to predict. In other words, systemic risks are undiversifiable risks as they impact the overall market, not just a particular stock or industry.
To manage systemic risks, investors should include diverse assets such as cash, real estate, and fixed-income securities in their portfolio, apart from equity. Each of these assets will react differently to systemic risks, which will help you manage the risk.
Unsystematic risk
Unsystematic risk is unique to a company or an industry and hence comparatively easy to manage. Unsystematic risk is categorized as:
- Business risk
- Operational risk
- Financial risk
These risks arise when there is some uncertainty in a company or an industry. Some common examples of unsystematic risks include management changes, product recalls, new competitors for market share, financial reports, and internal strikes.
Unsystematic risk is relatively easy to manage. Investors often undertake portfolio diversification to beat unsystematic risk. A diversified portfolio that has shares of various companies and industries is a good bet against unsystematic risks.
Equity valuation
Equity valuation is a blanket term used by investors and analysts to determine a stock’s intrinsic value. Finding accurate valuation is considered a crucial element in the investment decision-making process.
Investment banks and financial analysts use various inputs to value a business:
- Macroeconomic variables
- Management of the business
- Financial health of the business
- Free cash flow of the business.
Analysts use these parameters to arrive at a valuation figure for a company. Various stakeholders use valuation to make investment decisions such as buy, hold, sell, etc. for a stock.
Equity vs. Debt Financing
Companies have two options when they need to raise capital for their business. They can either issue equity or borrow from the market.
The choice between equity financing and debt financing depends on factors such as the source of funds available to the company, its cash flow, and how important it is for the firm to maintain control over the decision-making process. Another criterion is the firm’s debt-to-equity ratio which shows how much of the company’s financing is proportionately provided by debt and equity.
This is because equity financing carries no repayment obligation and provides extra working capital that can be used to grow a business. However, equity financing will dilute the owner’s control over the organization as equity shareholders are partial owners of the company and enjoy voting rights.
Debt financing, on the other hand, does not require giving up a portion of ownership. Debt entails repayments and thus the organization’s free cash flow will be reduced as a fixed amount will have to be set aside to service the debt.
Ideally, an organization will use a mix of debt and equity financing to fund its capital needs.
Equity in personal finance
In personal finance, equity is money, any amount of money that belongs to an individual. This includes money held in assets like your car, house, and business and investments such as stocks, mutual funds, and fixed-income products.
Equity is tied to ownership. No matter the type of asset, equity represents the value the owner would keep after the asset is sold and all liabilities are covered.
A person’s equity increases when the value of the assets increases and the liability on them decreases.
Role of equity in financial markets
Equity is a tool to raise capital for companies. The companies raise money via initial public offering, popularly known as IPO. Investors have to subscribe to the IPO and once the offer ends, investors will be allotted shares on a pro-rated basis. Once the investors receive allotment, the shares will be listed on the stock exchange. This is known as the primary market.
Once the IPO is over and shares are listed, they will continue to trade on the stock exchange. This is known as the secondary market. The secondary market acts as a platform for investors to buy and sell shares of all listed companies. This is also known as the equity market.
Equity and wealth distribution
Equity comes from the French word “equité,” meaning fairness or justice. So, while equity means cash in personal finance and ownership in the case of stock investments, the word equity also has societal connotations.
Despite academic debates about rising global inequality, modern-day equity investment does help achieve the distribution of wealth to a certain extent. Not everyone can be a business owner and earn a profit from it. Equity investment fills this wide gap in society. A common man can also become a part owner in a business by investing in its shares and more importantly, expect to earn returns from the investment. For instance, if one company does well, all its investors in the broader market also stand to gain.
Case studies and examples
Equity financing has been used by India Inc. for a long time now. Diversified conglomerate Reliance Industries was the first company to bring an IPO after independence. Since then, India has had numerous IPOs, offering investors the opportunity to become stakeholders in prospective business growth. Though retail participation in the Indian stock market is still low, cheap internet costs and the increasing affordability of smartphones have drawn hordes of newbie investors to the market in recent years.
Conclusion
Equities are instruments to raise capital. Individuals who participate in this capital-raising exercise are called shareholders. Shareholders get partial ownership of the company, which also gives them voting rights on important company decisions.
Equities are also investment instruments that are traded on the stock exchange after their listing. In finance, the first lesson one learns is that risk is linked to reward when it comes to investments. Investors risk capital to invest in equity to get returns higher than that of safe assets such as fixed deposits and fixed-income securities.
FAQs
What is equity?
Equity is the amount of capital invested or held by the owner of a company. Equity is evaluated by the difference between liabilities and assets recorded on the balance sheet of a company.
What is equity in stocks?
Equity is simply the value of an investor’s stake in a company. It is represented by the value of shares an investor owns. Stock ownership gives shareholders access to potential capital gains and dividends.
Explain equity with an example
Equity is the amount of money that a company’s owner has put into it or owns. On a company’s balance sheet, the difference between its liabilities and assets shows how much equity the company has.
What is the equity of a company?
Equity refers to the extent of ownership of a company or an asset. For example, you have 10% equity as a shareholder in a manufacturing company. This means you own 10% of the manufacturing company.
What is equity and the formula for calculating it?
Equity is the residual value of a company after all its assets are liquidated and all liabilities to its creditors are paid. The formula for calculating equity: Total Equity = Total Assets – Total Liabilities.
