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In finance, equity is ownership of
asset In financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value of ownership that can ...
s that may have
debt Debt is an obligation that requires one party, the debtor, to pay money or other agreed-upon value to another party, the creditor. Debt is a deferred payment, or series of payments, which differentiates it from an immediate purchase. The ...
s or other liabilities attached to them. Equity is measured for accounting 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. 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 Equity is a particular body of law that was developed in the English Court of Chancery. Its general purpose is to provide a remedy for situations where the law is not flexible enough for the usual court system to deliver a fair resolution to a cas ...
that developed in England during the
Late Middle Ages The Late Middle Ages or Late Medieval Period was the period of European history lasting from AD 1300 to 1500. The Late Middle Ages followed the High Middle Ages and preceded the onset of the early modern period (and in much of Europe, the Renai ...
to meet the growing demands of commercial activity. While the older
common law In law, common law (also known as judicial precedent, judge-made law, or case law) is the body of law created by judges and similar quasi-judicial tribunals by virtue of being stated in written opinions."The common law is not a brooding omnipres ...
courts dealt with questions of
property title In property law, title is an intangible construct representing a bundle of rights in (to) a piece of property in which a party may own either a legal interest or equitable interest. The rights in the bundle may be separated and held by different ...
, 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 which the borrower pledges some asset (e.g. a car or property) as collateral for the loan, which then becomes a secured debt owed to the creditor who gives the loan. The debt is thus secured against the collateral, 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 A home equity loan is a type of loan in which the borrowers use the equity of their home as collateral. The loan amount is determined by the value of the property, and the value of the property is determined by an appraiser from the lending ins ...
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 ...
, 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 concerned with the summary, analysis and reporting of financial transactions related to a business. This involves the preparation of financial statements available for public use. Stockholders, ...
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 Accounting, also known as accountancy, is the measurement, processing, and communication of financial and non financial information about economic entities such as businesses and corporations. Accounting, which has been called the "languag ...
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, a balance sheet (also known as statement of financial position or statement of financial condition) is a summary of the financial balances of an individual or organization, whether it be a sole proprietorship, a Partnersh ...
(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 that may have any combination of features not possessed by common stock, including properties of both an equity and a debt inst ...
, share capital (or capital stock) and
capital surplus Capital surplus, also called share premium, is an account which may appear on a corporation's balance sheet, as a component of shareholders' equity, which represents the amount the corporation raises on the issue of shares in excess of their par ...
(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 which is bought back by the issuing company, reducing the amount of outstanding stock on the open market ("open market" including insiders' holdings). Stock repurchases are used as a tax efficie ...
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 is the accumulated net income of the corporation that is retained by the corporation at a particular point of time, such as at the end of the reporting period. At the end of that peri ...
(or accumulated deficit) is the running total of the business's net income and losses, excluding any
dividend A dividend is a distribution of profits by a corporation to its shareholders. When a corporation earns a profit or surplus, it is able to pay a portion of the profit as a dividend to shareholders. Any amount not distributed is taken to be re-i ...
s. In the
United Kingdom The United Kingdom of Great Britain and Northern Ireland, commonly known as the United Kingdom (UK) or Britain, is a country in Europe, off the north-western coast of the European mainland, continental mainland. It comprises England, Scotlan ...
and other countries that use its accounting methods, equity includes various
reserve Reserve or reserves may refer to: Places * Reserve, Kansas, a US city * Reserve, Louisiana, a census-designated place in St. John the Baptist Parish * Reserve, Montana, a census-designated place in Sheridan County * Reserve, New Mexico, a US vi ...
accounts that are used for particular reconciliations of the balance sheet. Another financial statement, the statement of changes in equity, 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 or can be resold with a capital gain. 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 "private" ownership used in many jurisdictions, in contrast to a publicly listed company, with some differences from country to country. Examples include the '' LLC'' in the United St ...
, 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 process, the owners have a
residual claim The 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 th ...
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 in which a person's financial liability is limited to a fixed sum, most commonly the value of a person's investment in a corporation, company or partnership. If a company that provides limited liability to it ...
, 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 shareholders, 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 valuation In 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 fr ...
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 and finance, present value (PV), also known as present discounted value, is the value of an expected income stream determined as of the date of valuation. The present value is usually less than the future value because money has inte ...
of the portion of its equity and future earnings that are payable to stockholders. Advocates of this method have included Benjamin Graham, 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. He is one of the most successful investors in the world and has a net ...
. 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 model The 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 on the value of the whole company (including the liabilities), 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 * Common ordinary equity * Net worth *
Private equity In the field of finance, the term private equity (PE) refers to investment funds, usually limited partnerships (LP), which buy and restructure financially weak companies that produce goods and provide services. A private-equity fund is both a t ...


References

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