Equity

Equity is a broad term. In its most general meaning, equity is an equilibrium, or “a state when the two parties are even.” Jack fulfilled all his obligations to Tom and vice versa.

In corporate finance, the concept of equity is applied very broadly, and it all gets pretty nasty, but we will get to that.

Most often, equity refers to shareholder equity — the value of a shareholder’s stock derived from the company’s balance sheet. In other words, shareholder equity is the book value or remaining value of your interest.  

Read on to find out what this means in layman’s terms.

History of the term
Shareholder equity
Why would a company start selling equity shares on the stock market?
Private equity
Use of equity in a startup
More on an individual’s equity
Intangible equity

History of the term

The colloquial nature of the word “equity” in finance is based on its history in English law. According to an Oxford course given by F.W. Maitland, ”equity” as a legal term appeared thanks to the royal courts of late medieval England. Back then, there was a dual court system in place: there was the King’s Court and the Court of Chancery, run by the Lord Chancellor. The principle of equity was the reason why such dualism appeared.

The courts of that time were supposed to uphold justice aka equity.  But The King’s Court was unable to deliver justice for crimes that had been committed because of the complex and imperfect law it was relying on. This was why a separate institution, the Court of Chancery, developed over time. Their procedures were simpler, and the rulings were always adapted to specific cases. Thus, they got a lot closer to equity. And later they started calling the Chancery Court the Equity Court.

The principle of equity can be simply described as “a state when a victim is compensated for all the damage they suffered.” For example, if something was stolen from a person, just giving the stolen thing back wouldn’t do the trick. An artisan whose tools had been stolen could no longer produce his product, and thus suffered serious financial losses that would have to be covered, too.

Shareholder equity

Today, most of the time when you hear the word “Equity” it refers to Shareholder Equity. By buying stock, you buy part of the business based on its current value on the market.

This creates inequity. You spent your money and didn’t immediately get anything for it in return.

As the company's stock grows in value, so does the inequity. The company 'owes' you more money than you actually paid for your share. You may resell this inequity to someone and in this way make a profit.

Assets that are components of shareholder equity

Now, let’s look at the company assets that you secure with your investment:

  • Any retained earnings and whatever percentage of the net earnings that are not put towards paying dividends. Retained earnings are the piggy bank of the company.
  • Treasury shares. These are shares that the company decided to buy back from its shareholders. Treasury shares act as a contra account to investor capital and retained earnings accounts because they represent equity not turned into cash for the company.
  • Additional Paid-up Capital or Share Premium. This is how much a company earned while selling shares, meaning how much more than the book value of a share the customer paid.
  • Revaluation Surplus. This appears when assets after revaluation turn out to be more valuable than you thought they would be.
  • Common and preferred stock.

If a corporation goes bankrupt, components from the list above are used to cover the company’s debt. If there’s anything left after that, the money is equally distributed between its shareholders. The amount a shareholder gets back depends on the number of shares they had.

To see if a company has enough resources to cover their debt to the stockholders, investors look at the Equity Multiplier. This metric is very easy to calculate as shown below:

Equity Multiplier = Book Value of the Company/Shareholder Equity

A higher ratio means that more assets were funded by debt than by equity. In other words, investors funded fewer assets than creditors did.

When a firm’s assets are primarily funded by debt, the firm is considered to be highly leveraged and more risky for investors. This also means that current investors actually own less of the company assets than current creditors.

For example, if the Equity Multiplier is 5, it means that 20% of the company’s assets is balanced by Shareholder Equity The remainder is financed by its liability. If it goes under, you won’t even recover the book value of your shares as the remaining assets will be used to pay off the company’s debt first.

Why would a company start selling equity shares on the stock market?

To secure funding.

Before part of the company is traded either publicly or privately, there needs to be a very careful consideration of what the company’s current assets are worth and how the money raised can be spent in the most effective way.

Think of it as pitching your product (company) to investors. Only this time, you can’t sell face-to-face. Your case has to be extra solid on paper to be convincing. But, if successful, the business will rise to a whole new level.

If everything goes well the first time, you can do it again. Issue more equity in your business, thus raising even more money and growing the company even bigger.

Sometimes big companies issue equity if they need to quickly pay off the debts that are somehow interfering with them moving forward.

There’s also something called PIPE. PIPE stands for Private Investment in a Public Company. A good example of this is when public companies looking to sell shares at bulk to private investment funds usually sell each share cheaper than it would sell on the market. But they get a lot of cash very quickly this way.

Private equity

So far, we have only looked at publicly traded companies. But, the concept can be applied to small businesses as well.

But there is a catch. Publicly traded companies are always aware of what a share of their business is sold for and how it correlates with the book value of the share because they have data from the market.

For private companies, it is not that easy. If you want to sell your house, you already know what it cost you when you bought it, and you can find out how much of your mortgage you still have to pay off. But to learn the house’s market value, you need to do research.

Every single method of calculating the value of equity in private companies basically calculates how good the return on investment is. Or, in other words, it calculates if your stock can grow enough to justify the investment in it.

There are two general ways to see what equity in your company is worth. Note that this applies to companies that are not publicly traded yet:

  • Capital Asset Pricing Model or CAPM;
  • And Bond Yield plus Risk Premium Approach (this one usually goes without an abbreviation and is simple despite its long name).

Let’s look at them one by one.

Capital asset pricing model

Basically you make a conservative prediction on how much this influx of capital is going to grow your business. To do so, investors look at the relevant stock market indexes that show how companies in similar lines of trade and in similar economic circumstances fare ten years after investment.

Cost of equity share = Current Assets Cost x (Risk-free Rate + Risk Coefficient x (Market Return – Risk-free Rate))

Components in brackets are the ones that adjust for fluctuations in the market:

  • Risk-free Rate is the annual interest of a treasury bond of the country that the company is based in;
  • Risk Coefficient determines how risky an investment is; it’s based on comparing the certain's stock ‘riskiness’ to the ‘riskiness of the market;
  • Market Return is the average return rate for similar stocks.

Bond Yield plus Risk Premium

This method is simpler than the first one. But before you start to calculate it you need to answer three questions first:

  1. How much is the book value of the company now?
  2. How much of it are you willing to use as loan security?
  3. What is the probability of you going under in the foreseeable future?

Having this sorted out, you take the amount you are willing to use as security (S), multiply it by the interest rate of government bonds (B) and adjust for the risk of your business going broke (P).

Cost of a share = S x (B + P)

Use of equity in a startup

Many startups use equity as a job market leverage. Trading equity shares for labour helps to find talented professionals for your business at the startup stage when you can’t compete with the big guys salary-wise.

It’s also a good idea to use equity shares as an incentive for people who already work for you. It is known as Sweat Equity and was quite a popular motivational tool throughout the ’50s and ’60s. Nowadays, it is mostly reserved for the top professionals of the company and its executives.

More on an individual’s equity

In real estate, Householder Equity is what you get in cash when you sell the house after paying what is left of the mortgage.

Householder equity is a great source of collateral. For many individuals, their houses are their most expensive possession. And if they are looking to take out a loan, they may as well use a share of their home equity as a source of financing.

There are a variety of financial instruments that use home equity as a factor. You can get a home equity loan, which is a lot like a second mortgage for a portion of the house.

Mike wants to start his own business and restore vintage cars. He needs a car lift, a garage, a dyno-track, and lots of other pretty expensive things. Mike is very good both at fixing cars and recognizing future classics. But fixing cars is not cheap, and neither is buying future classics and waiting for them to become actual classics.

He has a beautiful apartment in Chelsea, which is worth £850,000. He still has to pay off £25,000 in mortgage, but he has a good job in the City, and his credit history is great. His homeowner’s equity is £825,000 at the moment.

He borrows £400,000 at an annual rate of 6%. Then he rents himself a garage, leases lifts, buys a couple of cars and spare parts for them, all for £250,000 and still has £150,000 to get him started.

You go, Mike!

Intangible equity

Most of the time, it is hard to determine the value of intangible assets. They sit in the books as expenses, but it is obvious that they are not only that!

In the case of a brand, it is pretty easy to express the value of it or its equity.

The maximum amount of money you are willing to pay on top of generic brand prices to get something you know well is the brand value.

Imagine yourself in a supermarket. There’s a shelf of soft drinks right in front of you. There’s a can of Coke, a can of Koke, and a can Goke. In most cases, you want to buy Coke but still, pay some attention to Koke and Goke. Coke is somewhat more expensive than the rest. You still buy it.

Sometimes brand equity can even be negative.

Back in the 1980s in the U.S., there was a huge news story that Audi cars were prone to “sudden unintended acceleration.” Even though no defect was found in the cars, the damage to the brand was already done. Because of Audi’s bad reputation, the sales dropped.

This example shows that because of Audi’s bad reputation, customers chose other brands. The sales of cars didn’t drop as a whole. It was just Audi cars that people wouldn't buy.

For many years Audi was struggling to mitigate this PR disaster by launching multiple recalls.  

At the same time, Mercedes and BMW, who are Audi’s direct competitors on the American market, grew their sales. Data from carsalesbase.com shows that all three of these companies (spreadsheet for BMW, spreadsheet for Mercedes) started the decade with a similar number of cars sold, but by 1987, both Mercedes-Benz and BMW had reached 100,000 cars per year, while Audi lagged behind.

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