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What is equity? Finance Definition and Examples

Equity constitutes an important part of the financial vocabulary, but its multiple meanings can make it difficult to understand.

What is Equity: Summary Table

🙅 Is investing in equity good?Yes, returns are great but it is also risky
💷 Is cash equity?No
❓ How do I invest in equity?By investing in the stock market
🧮 How is equity calculated?Equity = Total assets – Total liabilities

Here, we’ll help you get to grips with the concept by breaking down not just what equity really means, but how it works and how you can make it work for you.

What is equity?

In general terms, equity is the value of an asset after factoring in all of its liabilities (financial debt or obligations). It refers to a person’s ownership of an asset after the liabilities have been made off.

As an example, equity could represent the value of your home, after all the debts attached to it (i.e. mortgage) are taken into consideration and paid down. This asset’s equity is said to increase as the mortgage is paid out and as the value of the property rises.

We will explain how to calculate equity in a bit more detail later on.

How does equity work?

Shareholders own part of a company, and they may be either public or private companies. Each share has a class, and each class of shares is assigned rights and privileges. Equity means “equal” in the context of shares.

Companies raise capital and expand their business by issuing new shares. These shares are then placed on secondary markets such as the stock market, where investors can purchase them in exchange for cash. As a result, investors earn income on company shares and can get a return on equity due to the value appreciation of their equity investments. But, investment risk is always affiliated with equity.

Types Of Equity

There are several types of equity depending on the type of investment. They include:

  • Owner equity refers to the value of assets owned by the owners of the business.
  • Private equity refers to the amount of equity held in a private company
  • Shareholder equity refers to the equity owned by the stockholders via stocks
  • Brand equity refers to intangible assets such as consumer loyalty, and brand presence
  • Home equity refers to the value of a homeowner’s interest in a home

Types of equity for normal investors

In the world of investing, shareholder equity typically refers to the value attached to a person’s ownership of a business and is generally understood in the form of shares. An investment strategy makes use of shareholder equity to build portfolios and manage risks.

There are three basic types of equity for normal investors to choose from:

  • Common stock
  • Preferred shares
  • ETF shares

Common stock, often referred to as ordinary shares, represents the value of ownership in a corporation. Common stockholders receive dividends (payments) on any capital gains (profit) made by the business, based on the number of shares they hold.

Preferred shares are units in a business that have a higher claim to the earnings and assets of the business than normal stock. In most cases, preferred shares have a dividend that takes priority over normal shares. What this means is that in the event of liquidation, preferred shareholders will have access to a company’s assets before the common stockholders.

A drawback to investing in single companies is that you can be over-exposed to its performance. That’s great if the business does well, but bad news if it things don’t go to plan. That’s why investors look for diversification with their investments to manage this risk. But diversification is a difficult thing to get right yourself, not to mention the fact that it’s expensive.

ETFs (exchange-traded funds) allow investors to achieve diversification in a simple and affordable way. They consist of a basket of investments that aim to replicate an index, specific commodity, bond, or basket of assets. ETFs (Exchange-Traded Fund) act like shares on the stock market and can be traded in seconds, providing investors with both transparency and flexibility.

Private equity

Private equity refers to the value of ownership in a company or entity that is not listed or traded publicly. In some cases, private equity may also take the form of shares of publicly listed companies, which are acquired by investors with the aim of making them private.

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The private equity industry mainly involves high-net-worth individuals and institutional investors.

Calculating equity: Book value & market value

There are two ways of calculating equity. You can use the market value of equity or the book value of equity method. 

The market value for equity is used in finance to calculate how much a business or company is worth. Also, known as market capitalization, it is calculated by multiplying the current stock price by the total number of outstanding shares. 

On the other hand, book value calculation for equity is used in accounting and it is also known as shareholder’s equity. A simple way of remembering how to calculate equity using book value is through the acronym ALE. 

Equity = Total Assets – Total Liabilities

For companies, this information can be found in their balance sheet. It’s all quite simple, but why does this matter?

Shareholder equity is used by analysts to judge the financial health of a business and represents the net value of a company. Shareholder equity can be both positive – when assets are greater than liabilities – and negative – when the opposite is true. Such value influences an individual’s investment decisions, seeing that the latter constitutes a riskier choice.

Investing in equities

Equities are seen as a riskier asset class that holds the potential for high returns. Before investing in equities you need to consider the risk associated with your specific investment, as well as wider economic risk, interest rate risk, foreign-exchange risk, geopolitical risk and the impact of taxes.

You’ll also need to consider how fees and charges will impact your returns, as well as the impact of compounding and pound cost averaging.

You can manage the risk in your portfolio by diversifying your investments and spreading your money across different asset classes. Building the right portfolio to reach your financial goals, though, can be a difficult task to get right.

Luckily, Moneyfarm does this for you, matching you to an investment portfolio that’s built to reflect your investor profile and time horizon. The hardest thing you need to do is decide when you want to invest, and with how much.

Photo by Robert Bye on Unsplash

FAQ

What is equity in investment?

Equity investment involves investing in a company by purchasing company shares in the stock market.

How do equity investors get paid?

There are several ways equity investors get paid. They get returns on their investment through dividends, interests, share profits from price appreciation, and even tax breaks. 

How much should I invest in equity?

You can invest as much as you can afford. How much you invest depends on your investor profile, age, financial situation, goals, etc. For example, if you are in your 30s, you can have a 70% equity investment, but if you are closer to retirement, then less equity investment is advised.

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