I can't understand what equity is

Question

I know there is dozen materials out there on the internet, but I can't wrap my head around equity. From the accounting equation I know that assets = liabilities + equity.

• assets are the things the company owns
• liabilities are the things that company needs to give back at some point

But what is equity? For example, if we consider stocks. The company emits stocks at some price (let's say 100$ per share). So the company gets cash (which is an asset), but what do these stocks balance with in the equation (they are not liabilities, or are they?)?

Also, what is the point of trading these stocks on the secondary market for the price that is higher than 100$? I know that there is supply and demand, but why people even want to purchase these stocks (let's consider a retail investor that buys a few stocks so he/she never has an intention to sit on the company's board of directors)?

Answer 1

Consider something tangible: a car. You buy it for $20,000 and borrow $10,000 of that. At some point in the future, the car is worth $15,000 and you still owe $9,000. Your equity is the difference - $6,000. (It has gone down, because cars lose value over time and generally do so faster than you pay the loan back.)

Or consider something that goes up, such as real estate. You buy for a million, borrowing half a million. Later, it is worth 1.5 million and you owe $200,000 which is 0.2 million. Your equity is 1.3 million.

So for a company as a whole, it owns some offices and some equipment and assorted other stuff that is maybe 10 million dollars, and it has various loans that add up to 1 million, its equity is 9 million. Same calculation, just with a lot more items in it.

A stock is neither an asset nor a liability. A person who owns a stock owns a fraction of a company. So a very simple way to look at it is to say well the company is worth 9 million and there are a million shares so each share is worth $9. But in fact people may be willing to pay more than that (if they think it will go up, if it pays a nice dividend, if they need to put their money somewhere that at least won't go down) or less than that (if they think it will go down, or if other $9 shares are more appealing). Understanding the price of a share may start with understanding the net value of all the stuff the company owns and owes, but it sure doesn't end there. Many many books have been written on this and you probably need to read more than one to get the information you need.

As for why people buy stocks, they do so either to earn the dividend or because they believe they can sell it for more later, or perhaps both. There are various complications related to the tax rules where they live, that might make stocks more appealing than earning interest from a deposit of some kind, and again this is something covered in hundreds of pages, not hundreds of words. But it boils down to believing they can sell it for more money to someone else later.

Answer 2

Equity is the amount of value that's yours.

If you get $50000 by borrowing $50000 from the bank, you didn't really get $50000. You have $50000 cash, but it's not really yours.

If you earned $50000, then you created $50000 equity. You are worth $50000.

With stocks, the equity is what the company is worth. If the company is worth $50000, because it created $50000 of useful stuff, or because investors think it's about to, then that's the equity.

Answer 3

Kate explains the first question well, but I think there's something to add for the second:

People buy stocks not just for the current equity value (assets - liabilities), but for a share of future profits. As companies earn profits, they either keep the money (increases equity), buy assets (increasing equity), pay off debt (increasing equity) or distribute it to shareholders (transfers equity to shareholders). So the current equity is often not as valuable as the potential future equity that the shareholder is entitled to.

That's why startups often have negative equity (loads of debt and few assets) but large stock prices, because there's an expectation that their business will be profitable in the future.

Answer 4

But what is equity? For example, if we consider stocks. The company emits stocks at some price (let's say 100$ per share). The company gets cash (which is an asset), but what do these stocks balance within the equity equation (they are not liabilities, or are they?)?

I think one part of your question may have been missed. It seems you are asking about how stocks fit into assets and liabilities and it's a good question. It's made even more confusing by the term 'equities' being used to describe stocks.

When a company issues new stock for sale, it is selling some portion of the ownership of the company. In return, the company receives cash (keeping it simple,) and that cash is added to the assets of the company. Typically, that won't sit in a bank account. It will be used to fund operations or investments.

So, isn't that ownership a liability? In a general sense, yes, sort of but not in an accounting sense. The stockholders of a company are literally the owners of that company. The exchange of stock (ownership) for cash is a complete transaction.

It might help to consider another way a company can raise funds outside of income: issuing debt e.g.: bonds. In that case, there is cash added to the assets but there is also a liability for the debt added as well. So why do companies take on debt when they can sell stock instead? When that stock is sold, it dilutes the existing ownership. The existing owners don't really want their piece of the pie to shrink, but they should accept that outcome if that means the pie gets a lot larger.

Answer 5

Accounting

• Assets are what you have. The tangible and intangible things that you control that are worth money.
• Liabilities are what you owe. The debts that you are obliged to repay to other people at some point in the future.
• Equity is what you own. That is, how much of the assets you get to keep after you repay every one of your liabilities.

Equity is the accounting or book value of the company. It is not a particularly useful measure as all of this is theoretical point-in-time stuff. It’s not possible in most cases to immediately settle your debts and assets and liabilities will change, possibly second-by-second as the organisation does whatever business it does.

More useful measures are its value as a going concern which is the present day value of all the expected future cash flows the company will deliver to its owned; this is typically more than its book value. And it’s liquidation value which is what the owners would be left with if it stopped trading, sold all the assets for whatever it could get, and paid all the liabilities (including the ones that crystallised because of all the contracts you just broke); this is typically less than the book value. However, if the liquidation value is ever higher than the going concern value, it’s time to appoint a liquidator.

When a company creates and sells stocks on the primary market, it books both cash (an asset) and shareholder’s equity (an equity). There are no liabilities involved here from an accounting point of view.

Financial markets

An equity is a class of assets representing an ownership stake in a company. Other classes of assets include cash representing money in the bank, bonds representing a loan to a company or government, property representing an ownership stake in real estate, commodities representing an ownership stake in physical stuff like wheat or gold, and currencies representing ownership of foreign cash.

The trading of stocks on the secondary market does not affect the accounts of the company. Public companies are usually listed on a stock exchange which allows the free trading of shares in the company between anyone, however, there are some unlisted public companies. Owners of private companies must trade their shares privately and other owners can typically veto trades.

The value of a share on the secondary market its value as part of a going concern. Most relevantly, for the stockholder, the value of owning the share is the net present value (to them) of all the cash flows that that share will generate. This includes semi-annual dividends for as long as they hold the share (noting that some companies don’t pay dividends) plus the cash they will get when they ultimately sell it. Additionally, there are intangible benefits such as being able to attend and (possibly) vote at company meetings, and, if you own enough of the shares, the right to decide directly who one or more directors of the company will be (i.e. real control).

The share’s value to someone else is almost surely going to be different (higher or lower) than its value to you. And wildly different from the amount the company originally sold it for on the primary market, possibly many years ago. If someone is willing to pay you more for something you own than you think it’s worth, you should probably sell it to them.

However, that’s too simplistic for the way real people behave. There are always other reasons to sell (or buy) beyond an assessment of the net present value of future cash flows. For example:

• Perhaps you have an opportunity to buy a nice car or beach house. To get that thing you want you need cash which may mean you are willing to sell shares for less than you think they’re worth.
• Perhaps you’re dead and your executor wants to liquidate all your assets to distribute cash to the beneficiaries.
• Perhaps you’re making a bid for control of the company - the value of that one share that will give you control is obviously more than the 9,999 that won’t.
• Perhaps you have had an ethical epiphany and no longer want to own shares in companies that make weapons/alcohol/meat/fossil fuel/etc. or companies that finance those that do.
• Perhaps you had a tarot reading and the psychic told you there was going to be a stock market crash.
• Perhaps you own all the shares in your company and want to retire.

Just looking at the stock market, what it does is in its name: it’s a market for stocks. Just like a supermarket is a market for … groceries. It’s purpose is to bring together people who want to buy and people who want to sell, allow them to state the price their willing to pay or take respectively, and, if these overlap, make the deal happen. These days it’s all done automatically by computerisation but I’m just old enough to remember stock brokers on the floor shouting out those prices and finding each other over the din.

Law

While it’s not something I think you’re interested, equity is that part of law concerned with things that were dealt with by the now defunct Courts of Chancellery as distance from those dealt with by the Law Courts. It includes things like wills, trusts, and equitable remedies such as specific performance, injunctions, and unjust enrichment.

Generally

Equity is sometimes used as a synonym for fairness in a sociological context.

Answer 6

An asset is an item that has the possibility of creating value. If it does produce value, then there is a certain order in which people are entitled to that value. These seniority levels are generally sorted into two main seniority tiers. The higher seniority (that is, the people who have the first claim on the money) is "debt" or "bonds", and the lower is "equity" or "stocks". There can be further subdivisions, such as some bonds being more senior than other, and "preferred stock" being more senior than "common stock".

Bonds are also called "fixed income" because there is some fixed amount of money that the holders are entitled to. Every time the profit from an asset exceeds a seniority level, the remainder then goes to the next seniority level.

For example, suppose you have a $300k mortgage on your house. If you sell the house, the bank has dibs on the first $300k. Everything over $300k is yours free and clear. So if the appraised value of the house is $500k, then $300k of that is debt, and $200k of that is equity.

Equity is in some sense "skin in the game". It's the form of ownership that has the last claim to profits, and thus is the first to take a loss if the company doesn't do well, but it is also the form of ownership that gets all the profit after all the higher tiers are paid off, and it's also the form of ownership that has the most decision-making power.

The amount of equity is the value of this ownership. So suppose a company has $2m in outstanding debt. The equity owners (i.e. shareholders) have the right to have all profits above $2m. If the company has an equity of $8m, that means that the value of that right is $8m.

But what is equity? For example, if we consider stocks. The company emits stocks at some price (let's say 100$ per share). So the company gets cash (which is an asset), but what do these stocks balance with in the equation (they are not liabilities, or are they?)?

They don't balance with anything. When a company issues stock, the money that people spend buying the stock can be referred to with a variety of terms, such as "capital contributions" and "equity stake". The two ways that a company gains equity is profit and equity contributions (there's also mergers, but those can be analyzed as equity contributions). In the same way, if you have a mortgage, any money you pay towards the principal goes directly towards the equity, with no balancing it out.

From the perspective of the people buying the stock, they start with $100 in cash, and they end up with $100 of equity. They are simply transforming their money from one form to another.

Also, what is the point of trading these stocks on the secondary market for the price that is higher than 100$?

Presumably, the company is doing something useful with that $100. Once the company has made some profit, the value of the stock will go up.

Answer 7

I think part of your problem stems from your equation. That equation uses abbreviation: assets = liabilities + equity actually means assets value = sum(liability for all assets) + sum(equity for all assets)

Liability of an asset = how much you have to pay off before selling an asset.
Equity of an asset = how much you would retain if you paid off the liability and sold the asset.

Note that equity refers to liability and the equation calls it out separately, that’s because in the equation, liability is an aggregate over all of your assets, while for an individual asset, it is of course limited to that individual asset. Also, note that unless you have actually sold the asset (and thus it is no longer an asset, but a former asset), the equity is always somewhat speculative, an estimate of what you would get.

Stocks represent ownership in a company (and thus all of its assets). Each stock represents 1/number of stocks ownership of the company. If you buy 100% of the stock of a company, you own it entirely.

A company doesn’t just emit stock and set a value for it, it splits up the ownership and then sells that ownership and gets whatever price people are willing to pay.