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In finance, equity is ownership of
asset In financial accounting Financial accounting is the field of accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic entities such a ...
s that may have
debt Debt is an obligation that requires one party, the debtor A debtor or debitor is a legal entity (legal person) that owes a debt Debt is an obligation that requires one party, the debtor, to pay money or other agreed-upon value to ...

debt
s or other
liabilities Liability may refer to: Law * Legal liability, in both civil and criminal law ** Public liability, part of the law of tort which focuses on civil wrongs ** Product liability, the area of law in which manufacturers, distributors, suppliers, re ...
attached to them. Equity is measured for
accounting Accounting or Accountancy is the measurement ' Measurement is the number, numerical quantification (science), quantification of the variable and attribute (research), attributes of an object or event, which can be used to compare with other ob ...
purposes by subtracting liabilities from the value of the assets. For example, if someone owns a car worth $24,000 and owes $10,000 on the loan used to buy the car, the difference of $14,000 is equity. Equity can apply to a single asset, such as a car or house, or to an entire business. A business that needs to start up or expand its operations can sell its equity in order to raise cash that does not have to be repaid on a set schedule. When liabilities attached to an asset exceed its value, the difference is called a deficit and the asset is informally said to be "underwater" or "upside-down". In government finance or other non-profit settings, equity is known as "net position" or "net assets".


Origins

The term "equity" describes this type of ownership in English because it was regulated through the system of equity law that developed in England during the
Late Middle Ages The Late Middle Ages or Late Medieval Period was the period Period may refer to: Common uses * Era, a length or span of time * Full stop (or period), a punctuation mark Arts, entertainment, and media * Period (music), a concept in musical com ...
to meet the growing demands of commercial activity. While the older
common law In law, common law (also known as judicial precedent or judge-made law, or case law Case law is the collection of past legal decisions written by courts and similar tribunal A tribunal, generally, is any person or institution with authority ...
courts dealt with questions of property title, equity courts dealt with contractual interests in property. The same asset could have an owner in equity, who held the contractual interest, and a separate owner at law, who held the title indefinitely or until the contract was fulfilled. Contract disputes were examined with consideration of whether the terms and administration of the contract were fair—that is, equitable.


Single assets

Any asset that is purchased through a
secured loan A secured loan is a loan In finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money and investments. Savers an ...
is said to have equity. While the loan remains unpaid, the buyer does not fully own the asset. The lender has the right to repossess it if the buyer defaults, but only to recover the unpaid loan balance. The equity balance—the asset's market value reduced by the loan balance—measures the buyer's partial ownership. This may be different from the total amount that the buyer has paid on the loan, which includes interest expense and does not consider any change in the asset's value. When an asset has a deficit instead of equity, the terms of the loan determine whether the lender can recover it from the borrower. Houses are normally financed with non-recourse loans, in which the lender assumes a risk that the owner will default with a deficit, while other assets are financed with full-recourse loans that make the borrower responsible for any deficit. The equity of an asset can be used to secure additional liabilities. Common examples include
home equity loan #REDIRECT Home equity loan#REDIRECT Home equity loan A home equity loan is a type of loan In finance, a loan is the lending of money by one or more individuals, organizations, or other entities to other individuals, organizations etc. The re ...
s and home equity lines of credit. These increase the total liabilities attached to the asset and decrease the owner's equity.


Business entities

A business entity has a more complicated debt structure than a single asset. While some liabilities may be secured by specific assets of the business, others may be guaranteed by the assets of the entire business. If the business becomes
bankrupt Bankruptcy is a legal process through which people or other entities who cannot repay debts to creditors may seek relief from some or all of their debts. In most jurisdictions, bankruptcy is imposed by a court order, often initiated by the debtor. ...

bankrupt
, it can be required to raise money by selling assets. Yet the equity of the business, like the equity of an asset, approximately measures the amount of the assets that belongs to the owners of the business.


Accounting

Financial accounting Financial accounting is the field of accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic entities such as businesses and corporat ...
defines the equity of a business as the net balance of its assets reduced by its liabilities. For a business as a whole, this value is sometimes referred to as total equity, to distinguish it from the equity of a single asset. The fundamental
accounting equation The fundamental accounting equation, also called the balance sheet equation, represents the relationship between the assets, liability (accounting), liabilities, and Equity (finance), owner's equity of a person or business. It is the foundation for ...
requires that the total of liabilities and equity is equal to the total of all assets at the close of each accounting period. To satisfy this requirement, all events that affect total assets and total liabilities unequally must eventually be reported as changes in equity. Businesses summarize their equity in a
financial statement Financial statements (or financial reports) are formal records of the financial activities and position of a business, person, or other entity. Relevant financial information is presented in a structured manner and in a form which is easy to un ...
known as the
balance sheet In financial accounting Financial accounting is the field of accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic entities such a ...

balance sheet
(or statement of net position) which shows the total assets, the specific equity balances, and the total liabilities and equity (or deficit). Various types of equity can appear on a balance sheet, depending on the form and purpose of the business entity.
Preferred stock Preferred stock (also called preferred shares, preference shares, or simply preferreds) is a component of share capital __NOTOC__ A corporation's share capital
,
share capital __NOTOC__ A corporation's share capitalGlossary on Trade Financing Terms - S
in the U ...
(or capital stock) and
capital surplus Capital surplus, also called share premium, is an account which may appear on a corporation A corporation is an organization—usually a group of people or a company—authorized by the State (polity), state to act as a single entity (a lega ...
(or additional paid-in capital) reflect original contributions to the business from its investors or organizers.
Treasury stock A treasury stock or reacquired stock is stock In finance, stock (also capital stock) consists of all of the shares In financial markets A financial market is a market in which people trade financial securities and derivatives at ...
appears as a contra-equity balance (an offset to equity) that reflects the amount that the business has paid to repurchase stock from shareholders.
Retained earnings The retained earnings (also known as plowback) of a corporation A corporation is an organization—usually a group of people or a company—authorized by the State (polity), state to act as a single entity (a legal entity recognized by priva ...
(or accumulated deficit) is the running total of the business's net income and losses, excluding any
dividend A dividend is a distribution of profit Profit may refer to: Business and law * Profit (accounting), the difference between the purchase price and the costs of bringing to market * Profit (economics), normal profit and economic profit * Profit ...

dividend
s. In the
United Kingdom The United Kingdom of Great Britain and Northern Ireland, commonly known as the United Kingdom (UK) or Britain,Usage is mixed. The Guardian' and Telegraph' use Britain as a synonym for the United Kingdom. Some prefer to use Britain as shorth ...

United Kingdom
and other countries that use its accounting methods, equity includes various reserve accounts that are used for particular reconciliations of the balance sheet. Another financial statement, the
statement of changes in equity A statement of changes in equity and similarly the statement of changes in owner's equity for a , statement of changes in partners' equity for a , statement of changes in shareholders' equity for a or statement of changes in taxpayers' equity for ...
, details the changes in these equity accounts from one accounting period to the next. Several events can produce changes in a firm's equity. * Capital investments: Contributions of cash from outside the firm increase its base capital and capital surplus by the amount contributed. * Accumulated results: Income or losses may be accumulated in an equity account called "retained earnings" or "accumulated deficit", depending on its net balance. * Unrealized investment results: Changes in the value of securities that the firm owns, or foreign currency holdings, are accumulated in its equity. * Dividends: The firm reduces its retained earnings by the amount of cash payable to shareholders. * Stock repurchases: When the firm purchases shares into its own treasury, the amount paid for the stock is reflected in the treasury stock account. * Liquidation: A firm that liquidates with positive equity can distribute it to owners in one or several cash payments.


Investing

Equity investing is the business of purchasing stock in companies, either directly or from another investor, on the expectation that the stock will earn
dividends A dividend is a distribution of profits by a corporation A corporation is an organization—usually a group of people or a company—authorized by the state to act as a single entity (a legal entity recognized by private and public law 'b ...
or can be resold with a
capital gain Capital gain is an economic concept defined as the profit Profit may refer to: Business and law * Profit (accounting) Profit, in accounting Accounting or Accountancy is the measurement, processing, and communication of financial an ...
. Equity holders typically receive voting rights, meaning that they can vote on candidates for the board of directors and, if their holding is large enough, influence management decisions.


Legal foundations

Investors in a newly established firm must contribute an initial amount of capital to it so that it can begin to transact business. This contributed amount represents the investors' equity interest in the firm. In return, they receive shares of the company's stock. Under the model of a
private limited company A private limited company is any type of business entity in Privately held company, "private" ownership used in many jurisdictions, in contrast to a Public company, publicly listed company, with some differences from country to country. Examples ...
, the firm may keep contributed capital as long as it remains in business. If it liquidates, whether through a decision of the owners or through a
bankruptcy Bankruptcy is a legal process through which people or other entities who cannot repay debts to creditor A creditor or lender is a party 300px, '' Hip, Hip, Hurrah!'' (1888) by Peder Severin Krøyer, a painting portraying an artists' par ...

bankruptcy
process, the owners have a
residual claimThe residual claimant refers to the economic agent who has the sole remaining claim on an organization's net cash flows, i.e. after the deduction of precedent agents' claims, and therefore also bears the residual risk. Residual risk is defined in thi ...
on the firm's eventual equity. If the equity is negative (a deficit) then the unpaid creditors take a loss and the owners' claim is void. Under
limited liability Limited liability is a legal status where a person's financial liability Liability may refer to: Law * Legal liability, in both civil and criminal law ** Public liability, part of the law of tort which focuses on civil wrongs ** Product liabi ...
, owners are not required to pay the firm's debts themselves so long as the firm's books are in order and it has not involved the owners in fraud. When the owners of a firm are
shareholder A shareholder (in the United States often referred to as stockholder) of a corporation is an individual or legal entity (such as another corporation, a body politic, a Trust law, trust or partnership) that is registered by the corporation as the ...
s, their interest is called shareholders' equity. It is the difference between a company's assets and liabilities, and can be negative. If all shareholders are in one class, they share equally in ownership equity from all perspectives. It is not uncommon for companies to issue more than one class of stock, with each class having its own liquidation priority or voting rights. This complicates analysis for both
stock valuationIn financial markets, stock valuation is the method of calculating theoretical values of companies and their stocks. The main use of these methods is to predict future market prices, or more generally, potential market prices, and thus to profit fro ...
and accounting.


Valuation

A company's shareholder equity balance does not determine the price at which investors can sell its stock. Other relevant factors include the prospects and risks of its business, its access to necessary credit, and the difficulty of locating a buyer. According to the theory of intrinsic value, it is profitable to buy stock in a company when it is priced below the
present value In economics Economics () is a social science Social science is the Branches of science, branch of science devoted to the study of society, societies and the Social relation, relationships among individuals within those societies. ...
of the portion of its equity and future earnings that are payable to stockholders. Advocates of this method have included
Benjamin Graham Benjamin Graham (; né Grossbaum; May 9, 1894 – September 21, 1976) was a British-born American economist An economist is a professional and practitioner in the social science Social science is the Branches of science, branch of sci ...
, Philip Fisher and
Warren Buffett Warren Edward Buffett ( ; born August 30, 1930) is an American business magnate, investor, and philanthropist. He is currently the chairman and CEO of Berkshire Hathaway Berkshire Hathaway () is an American multinational Multinational may ...
. An equity investment will never have a negative market value (i.e. become a liability) even if the firm has a shareholder deficit, because the deficit is not the owners' responsibility. An alternate approach, exemplified by the "
Merton modelThe Merton model, developed by Robert C. Merton in 1974, is a widely used credit risk model. Analysts and investors utilize the Merton model to understand how capable a company is at meeting financial obligations, servicing its debt, and weighing ...
", values stock-equity as a
call option A call option, often simply labeled a "call", is a contract, between the buyer and the seller of the call option, to exchange a security Security is freedom from, or resilience against, potential Potential generally refers to a currently un ...

call option
on the value of the whole company (including the liabilities),
struckStruck is a surname. Notable people with the surname include: *Adolf Struck (1877–1911), German author *Hermann Struck (1876–1944), German artist *Karin Struck (1947–2006), German author *Paul Struck (1776-1820), German composer *Peter Struck ...
at the nominal value of the liabilities. The analogy with options arises in that limited liability protects equity investors: (i) where the value of the firm is less than the value of the outstanding debt, shareholders may, and therefore would, choose not to repay the firm's debt; (ii) where firm value is greater than debt value, the shareholders would choose to repay – i.e. exercise their option – and not to liquidate.


See also

*
Art equity Art equity is a proportionate ownership Ownership is the state or fact of exclusive right In Anglo-Saxon law Anglo-Saxon law (Old English Old English (, ), or Anglo-Saxon, is the earliest recorded form of the English language Englis ...
* Common ordinary equity *
Private equity Private equity (PE) typically refers to investment funds, generally organized as limited partnerships, that buy and restructure companies that are not publicly traded. Private equity is a type of equity and one of the asset classes consisti ...


References

{{Authority control Equity securities Balance sheet Stock market Shareholders Financial capital