What Is Equity?
Equity is a type of security that represents ownership. When a company raises capital, it can issue equity, debt, or both. While debt is a liability that must be repaid, equity offers ownership to a potential investor. A privately held company that goes public sells shares to investors as a means of financing its operations and broadening ownership.
An investor’s ownership in a company is proportionate to the number of shares they hold. For example, owning 10 percent of total shares represents a 10 percent ownership in a company. In countries such as in the U.S., investors may remain anonymous with their ownership in a company as long as they don’t meet or exceed a certain threshold that would trigger mandatory disclosure. Under Securities and Exchange Commission rules, any investor that owns at least 5 percent of a publicly traded company must disclose that ownership to the public.
Equity securities include common and preferred stock, and related securities such as warrants and convertible bonds. Equity is typically synonymous with stock or shares, and is often referred to by some investors and analysts as common stock, common shares, or ordinary shares. Equity holders are often referred to as stockholders or shareholders. In this article, equity, stock, and share are used interchangeably.
In terms of investment, equity ownership in publicly traded companies tends to be more risky than ownership in fixed-income securities like bonds because value is dictated by the open market such as a stock exchange, where shares are typically traded. Still, equities are a unique asset class, and fortunes can be made, and lost, in spectacular fashion.
Equity is a broad term and is used for different financial expressions. In accounting and finance, it is referred to as shareholders’ equity, which is the difference between assets and liabilities and represents the net value of a company. Homeowners refer to their home as home equity, which is the value of the home or landowner’s property after the cost of liabilities have been considered.
What Are the Most Common Types of Equity?
Aside from shareholders’ equity and home equity, equity typically refers to a security representing ownership in a company. Below are the different types of equity relating to ownership in publicly traded companies.
Common Equity
Common equity, or common stock, gives stockholders the right to vote on a company’s board of directors and other issues. This type of stock is used in calculating a company’s number of shares outstanding. Common stockholders are viewed as residual owners of a company because they receive what remains after income and assets have been settled.
Preferred Equity
Owners of preferred equities, or preferred stock, have priority over owners of common shares. Preferred equities implies what its name means: Owners are given preferential treatment on special dividends before common equity holders are awarded. They are also paid ahead of common shareholders when a company is liquidated. Preferred shares can often be converted into common stock, but until they are, they don’t come with voting rights.
Both common and preferred stock of a company are referred to as capital stock, which appears in the shareholders’ equity section of the balance sheet. A company typically places a nominal value, known as par value, on capital stock, and that is usually much less than the value in the open market.
What Are Other Securities Related to Equity?
Some securities are indirectly related to equity. Although they don’t provide direct ownership, these securities allow investors to convert their holdings into stock or to make passive investments.
Warrant
A warrant is a call option by a company on the issuance of new stock. A warrant holder has the right to exercise a warrant for the purchase of a company’s shares, and in doing so, the company issues new shares.
Convertible Debt
Debt that can be converted into common stock is known as convertible debt. A company that seeks to raise capital via debt but not stock can opt to sell convertible debt to an investor, who can receive shares in lieu of debt at an agreed-upon date.
Depositary Receipt
A company that trades its stock on its primary exchange but wants to trade in another country can do so in the form of a depositary receipt. This certificate is issued by a depositary bank and represents foreign stock held by the bank, usually a branch of the bank of the country where the original stock was issued. One depositary receipt is equivalent to one share, but trades in the currency of the country where the certificate is issued.
The most common type of depositary receipt is the American Depositary Receipt (ADR), which trades on the New York Stock Exchange and the Nasdaq. There are more than 2,000 types of ADRs from more than 70 countries. U.S. investors trade ADRs in dollars, avoiding the hassle of having to convert currencies.
For foreign holders of these stock certificates, ADRs do not provide the same rights, including the right to vote on a company’s agenda, as stockholders.
Equity Funds
Funds that are based on equities include equity mutual funds and equity exchange-traded funds (ETFs). Instead of direct stakes in stocks, investors are granted what is known as a unit, which represents a stake in the pool of stocks held in a fund. A unit can also be referred to as a share or a unit share. Units are in proportion to the amount of money invested in a fund.
What Is Private Equity?
A company that is closely held can sell its shares to another party. This is known as private equity. There are general partnerships that specialize in the purchase of privately held companies, and they are known as private equity firms. Venture capital firms are similar to private equity firms in that they invest in private equity but specifically at an early stage of a startup’s development.
Private equity firms usually take over a company by buying all of its shares and borrow the money for the acquisition in what’s known as a leveraged buyout. The typical goal of acquiring a privately held company is to manage it efficiently to make it more attractive to outside investors and eventually take the company public via an initial public offering.
How Do Equity Securities Create Value?
A company’s shares can go up in price, thus creating value for shareholders. Investors look at a company’s fundamentals, such as its ability to generate profit and pay dividends, to decide whether it might be a good investment that is likely to appreciate in value.
Frequently Asked Questions (FAQ)
The following are answers to some of the most common questions investors ask about equity.
Where Is Equity on the Balance Sheet?
Equity, or shareholders’ equity, appears at the bottom of a company’s balance sheet, below assets and liabilities. For publicly traded companies, the balance sheet is part of the financial statement filed quarterly and annually with the Securities and Exchange Commission.
How Does Shareholders’ Equity Differ From Book Value?
Book value is the net value of a company, which is how shareholders’ equity is calculated: assets minus liabilities. They differ in that shareholders’ equity can be calculated by adding a company’s capital stock to its retained earnings.
Are Equity and Stock (Share) the Same?
Yes. Equity can be used interchangeably with stock and share.
How Does Equity Work?
Equity offers investors potential ownership in a company. The more shares owned by an individual, the more they are likely to receive dividends. Depending on what type of shares are owned, a stockholder can exercise the right to vote on company matters and whom to elect as board directors.
When to Issue Equity?
Companies issue stock when they need to raise capital, or to provide equity to founders or employees as a form of compensation. When a private equity firm seeks to take public a private company, it takes that company through an initial public offering, usually to make a profit on its investment.
Can Equity Be Negative?
Equity represents ownership, and if a company becomes insolvent or enters bankruptcy proceedings, its value can go to zero but cannot be negative.
