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For example, if someone owns a car worth $15,000 (an asset), but owes $5,000 on a loan against that car (a liability), the car represents $10,000 of equity. Equity can be negative if liabilities exceed assets. Shareholders' equity (or stockholders' equity, shareholders' funds, shareholders' capital or similar terms) represents the equity of a company as divided among shareholders of common or preferred stock. Negative shareholders' equity is often referred to as a shareholders' deficit.
Alternatively, equity can also refer to a corporation's share capital (capital stock in American English). The value of the share capital depends on the corporation's future economic prospects. For a company in liquidation proceedings, the equity is that which remains after all liabilities have been paid.
When starting a business, the owners fund the business to finance various operations. Under the model of a private limited company, the business and its owners are separate entities, so the business is considered to owe these funds to its owners as a liability in the form of share capital. Throughout the business's existence, the equity of the business will be the difference between its assets and debt liabilities; this is the accounting equation.
When a business liquidates during bankruptcy, the proceeds from the assets are used to reimburse creditors. The creditors are ranked by priority, with secured creditors being paid first, other creditors being paid next, and owners being paid last. Owner's equity (also known as risk capital or liable capital) is this remaining or residual claim against assets, which is paid only after all other creditors are paid. In such cases where even creditors could not get enough money to pay their bills, the owner's equity is reduced to zero because nothing is left to reimburse it.
In financial accounting, owner's equity consists of the net assets of an entity. Net assets is the difference between the total assets and total liabilities. Equity appears on the balance sheet (also known as the statement of financial position), one of the four primary financial statements.
The assets of an entity can be both tangible and intangible items. Intangible assets include items such as brand names, copyrights or goodwill. Tangible assets include land, equipment, and cash. The types of accounts and their description that comprise the owner's equity depend on the nature of the entity and may include:
- Share capital (common stock)
- Preferred stock
- Capital surplus
- Retained earnings
- Treasury stock
- Stock options
The book value of equity will change in the case of the following events:
- Changes in assets relative to liabilities. For example, a profitable firm receives more cash for its products than the cost at which it produced these goods, and so in the act of making a profit, increases its retained earnings, therefore its shareholders' equity.
- Issue of new equity in which the firm obtains new capital increases the total shareholders' equity.
- Share repurchases, in which a firm returns money to investors, reducing on the asset side its financial assets, and on the liability side the shareholders' equity. For practical purposes (except for its tax consequences), share repurchasing is similar to a dividend payment. Rather than giving money to all shareholders immediately in the form of a dividend payment, a share repurchase reduces the number of shares outstanding.
- Dividends paid out to preferred stock owners are considered an expense to be subtracted from net income(from the point of view of the common share owners).
- Other reasons - Assets and liabilities can change without any effect being measured in the Income Statement under certain circumstances; for example, changes in accounting rules may be applied retroactively. Sometimes assets bought and held in other countries get translated back into the reporting currency at different exchange rates, resulting in a changed value.
When the owners are shareholders, the interest can be called shareholders' equity; the accounting remains the same, and it is ownership equity spread out among shareholders. If all shareholders are in one and the same class, they share equally in ownership equity from all perspectives. However, shareholders may allow different priority ranking among themselves by the use of share classes and options. This complicates analysis for both stock valuation and accounting.
Shareholders' equity is obtained by subtracting total liabilities from the total assets of the shareholders. These assets and liabilities can be:
- Equity (beginning of year)
- + net income
- − dividends
- +/− gain/loss from changes to the number of shares outstanding.
- = Equity (end of year) if one gets more money during the year or less or not anything
An equity investment generally refers to the buying and holding of shares of stock on a stock market by individuals and firms in anticipation of income from dividends and capital gains. Typically, equity holders receive voting rights, meaning that they can vote on candidates for the board of directors (shown on a diversification of the fund(s) and to obtain the skill of the professional fund managers in charge of the fund(s)). An alternative, which is usually employed by large private investors and pension funds, is to hold shares directly; in the institutional environment many clients who own portfolios have what are called segregated funds, as opposed to or in addition to the pooled mutual fund alternatives.
A calculation can be made to assess whether an equity is over or underpriced, compared with a long-term government bond. This is called the yield gap or Yield Ratio. It is the ratio of the dividend yield of an equity and that of the long-term bond.
Market value of equity stock
In the stock market, market price per share does not correspond to the equity per share calculated in the accounting statements. Equity stock valuations, which are often much higher, are based on other considerations related to the business' operating cash flow, profits and future prospects; some factors are derived from the accounting statement. See Valuation (finance) and specifically #Valuation overview; also Intrinsic value (finance) #Equity.
Note that while accounting equity can potentially be negative, market price per share is never negative since equity shares represent ownership in limited liability companies. The principle of limited liability guarantees that a shareholder's losses may never exceed his investment. See discussion under #Merton model below.
Under the "Merton model", the value of stock equity is modeled as a call option on the value of the whole company (including the liabilities), struck at the nominal value of the liabilities; and the equity market value thus depends on the volatility of the market value of the company assets. The idea here is that, in general, equity may be viewed as a call option on the firm: since the principle of limited liability protects equity investors, shareholders would choose not to repay the firm's debt where the value of the firm is less than the value of the outstanding debt; where firm value is greater than debt value, the shareholders would choose to repay - i.e. exercise their option - and not to liquidate. See Business valuation #Option pricing approaches.
This is the first example of a "structural model", where bankruptcy is modeled using a microeconomic model of the firm's capital structure - it treats bankruptcy as a continuous probability of default, where, on the random occurrence of default, the stock price of the defaulting company is assumed to go to zero.  This microeconomic approach, to some extent, allows us to answer the question "what are the economic causes of default?". (Structural models are distinct from "reduced form models" - such as Jarrow–Turnbull - where bankruptcy is modeled as a statistical process.)
Equity in real estate
The notion of equity as it relates to real estate derives from the concept called equity of redemption. This equity is a property right valued at the difference between the market value of the property and the amount of any mortgage or other encumbrance.
- IFRS Framework quotation: International Accounting Standards Board F.49(c)
- Example of Balance Sheet
- Hervé Stolowy; Michel Lebas (January 2006). Financial Accounting and Reporting: A Global Perspective. Cengage Learning EMEA. p. 42. ISBN 1-84480-250-7.
- Merton, Robert C. (1974). "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates". Journal of Finance. 29 (2): 449–470. doi:10.1111/j.1540-6261.1974.tb03058.x.
- Robert Merton, “Option Pricing When Underlying Stock Returns are Discontinuous” Journal of Financial Economics, 3, January–March, 1976, pp. 125–44.
- Nonlinear valuation and XVA under credit risk, collateral margins and Funding Costs. Prof. Damiano Brigo, UCLouvain