There is a lot to learn when you begin investing: the language, the connections, how to make your money work for you—the list goes on. Taking charge of your financial health can be intimidating, and there are numerous investment opportunities out there to choose from. A great place to start your journey is by diving into the question, “what is equity?”
Equity is a word you will hear throughout your career as an investor, and it’s one you should learn early on. By taking time to understand the basics, you can gain confidence in your investing knowledge and take steps to start building your portfolio. Keep reading to learn exactly what equity is and how to make it work for you.
What Is Equity?
Equity is the total value of an asset after subtracting debts and liabilities. The term can be used in various contexts, such as when looking at business ownership, real estate, and other financial assets. The amount of equity you have in a given asset serves to measure your ownership stake. For example, if you own a house valued at $250,000 and have $40,000 left on the mortgage, your total equity in the property would be $210,000.
Equity is a standard metric in the business world, as it can provide a clearer picture of a company’s financial health. In this context, it is commonly referred to as shareholder or owner’s equity. If a company was liquidated or acquired, equity would be used to determine how much shareholders and owners were paid at that time.
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How To Calculate Equity
It is important to learn how to calculate equity so you can measure the value held in your investments. Equity can be determine with the following formula:
Many business owners will regularly determine the value of their equity to gauge their company’s financial status. The following steps can help walk you through the process:
Start by adding up the total value of the asset or company. This will involve combining the value of any fixed assets, cash, prepaid expenses, and more.
Determine the total liabilities held. Consider outstanding debts, loans, mortgages, and owed taxes.
Once you are confident in the value of the asset and liabilities, subtract to get the total equity.
Equity On The Balance Sheet
A balance sheet is used in accounting to record the total earnings and costs associated with business operations. It can also indicate the total equity held by business owners, though this is not always the case. For example, if a company generates a large amount of income without a lot of tangible assets, the balance sheet may not be as helpful in evaluating the company’s performance. Instead, equity on a balance sheet can be used with other metrics to get a complete picture of a company’s overall finances.
Types Of Equity
There are a few different types of equity depending on the investment at hand. Take time to learn what each type of equity refers to, you never know when it might help you evaluate an investment. Here are some of the different equity types:
What Is Owner Equity?
Owner equity refers to the value of a company that the business owners hold. Think about a local coffee shop with two business partners as the owners. In this case, owner equity refers to the value of the coffee shop held by each owner (minus the total liabilities). Because the coffee shop is not a public company, the equity is not expressed as stocks or shares. Owner equity can be used in a variety of business contexts.
What Is Private Equity?
In its simplest form, private equity is a valuation tool used to evaluate private companies (those that haven’t executed an initial public offering). The amount of equity held in a private company helps paint a clearer picture as to how much it may be valued at. However, a more comprehensive breakdown will reveal that private equity is essentially what the company is worth after accounting for and subtracting liabilities from assets.
Not unlike publicly traded companies, private equity is distributed to individual owners and employees in the form of shares. It is worth noting, however, that private equity is often used as a tool to raise capital. High-growth companies on the private market may sell equitable shares in private placements to a number of entities: pension funds, university endowments, insurance companies, and accredited individuals—just to name a few. In selling shares, the private company will receive capital it may deploy in future endeavors like growth and acquisition.
What Is Shareholder Equity?
Shareholder equity is the most common type of equity in everyday investing, though it is more frequently referred to as stocks. This type of equity is the value of the shares an individual has in a company. Shareholder equity, or stock prices, can be used when analyzing how well a company is performing financially, though it is not the only metric investors should be aware of.
What Is Brand Equity?
Brand equity is an intangible asset that can positively or negatively impact the value of a business. It refers to the brand’s inherent value by measuring factors like consumer loyalty, brand presence, and more. A great example of brand equity can be seen by looking at Kleenex. Think about how often you hear people refer to tissues by the brand name rather than the product name. This kind of market presence has value to business owners and is commonly called brand equity.
What Is Home Equity?
Real estate is another common context where equity is used to measure value. The amount of equity a homeowner has can be determined by taking the property value and subtracting the outstanding mortgage amount. Homeowners build up equity when making an initial down payment, monthly mortgage payments, and as the property value appreciates over time.
How Does Shareholder Equity Work?
The concepts which lend themselves shareholder equity can get convoluted rather fast, which begs the question: How does shareholder equity work?
Simply put, shareholder equity is used to raise capital. While there is more than one way to raise cash (like issuing debt in the form of a loan or bonds), shareholder equity can be sold to investors and institutions. In return for distributing equitable interest in the company to subsequent investors, the private entity will receive cash equivalents that it may use to grow the company, and complete mergers and acquisitions.
How To Calculate Shareholder Equity
Calculating shareholder equity for a private company differs from that of a public company. Whereas public companies can rely on traditional market metrics like share price and market capitalization, private companies are not granted the same luxury. Instead, private companies resort to using a simple equation: Shareholder’s equity is equal to the company’s total assets minus its total liabilities.
For a step-by-step walkthrough on how to calculate shareholder equity, please reference the following:
Add up all of the assets on the company’s balance sheet
Add up all of the liabilities on the company’s balance sheet
Subtract all of the liabilities from the total assets
The resulting number is the shareholder’s equity
All of these variables can be found on the company’s balance sheet.
Example Of Shareholder Equity
A shareholder equity calculator provides some insight into a private company’s financials. However, a company’s financials are more than just a few numbers; there are several line items that make up both the assets and liabilities. As a result, it may be more beneficial for some people to view a more comprehensive breakdown.
Let’s say, for example, a new software company has the following assets:
Cans & Cash Equivalents: $100,000
Notes & Accounts Receivable: $200,000
Property & Equipment: $70,000
According to this list, the software company has $500,000 in assets. Now, with the assets added up, it is time to account for the same company’s liabilities:
Notes & Loans Payable: $$50,000
Income Taxes & Accrued Liabilities: $100,000
Long-Term Debt: $40,000
Long-Term Obligations To Equity Companies: $25,000
Other Obligations: $35,000
The line items above suggest the software company has about $500,000 in assets and $250,000 in liabilities. Now, all that’s left to do is subtract the liabilities from the assets, which results in a combined shareholder equity of $250,000.
Equity As Employee Compensation
It is commonplace for both public and private companies to compensate their employees with equity. In fact, many companies use equity as employee compensation in order to attract the best talent or to keep current employees happy. In addition to regular paychecks, health insurance, and a number of other amenities, equity is simply another form of motivation that will reward handwork with an even greater return. If for nothing else, employees who receive equity in a company may see their hard work returned in the form of share price increases over a long period of time.
How companies decide to distribute equity will vary from business to business. While some companies offer a specific monetary amount, others may set a number on the shares distributed to each employee. Additionally, employees will have to wait through what is called a vesting period, which is a specific amount of time before the employee can own or sell their shares.
Equity Vs. Return On Equity (ROE)
Return on equity (ROE) is another standard metric used to gauge a company’s financial health; however, it measures profitability rather than ownership. ROE is calculated by looking at net income divided by the total shareholder equity. Because shareholder equity takes debts and liabilities into account, the resulting ROE is a good measure of a company’s incoming profits. ROE is primarily used in business contexts to determine profitability.
How Real Estate Investors Should Use Equity
Equity can be easily overlooked in real estate, as it is a relatively unassuming investment vehicle. However, as you build equity in an investment property, it is important to learn how to use it to your advantage. Even as a homeowner, you may be tempted to use equity for some immediate needs or even wants. However, where do you draw the line? What warrants funding from the equity you have worked so hard to build up?
Unfortunately, these questions can’t be answered with a simple yes or no. While an easy answer would be nice, decisions regarding the allocation of equity are complicated and depend heavily on your particular situation. Having said that, let’s take a look at some common home equity cash-out scenarios and why they may – or may not – make sense for you:
According to Kelly Kockos, the home equity product manager for Wells Fargo in San Francisco, home improvements are the quintessential reason most homeowners dip into their equity. More and more homeowners are realizing the benefits of allocating their equity into renovation budgets. The upside is evident, as you are essentially investing in your own property. With additional funds, homeowners can remodel kitchens, bathrooms, bedrooms, and even basements. The opportunity is especially attractive if the house in question has increased in value. The larger equity cushion makes the decision much easier.
“You can leverage that equity at a low rate to improve your home and make it more comfortable,” says Justin Lopatin, vice president of mortgage lending for PERL Mortgage in Chicago. “If you can tap into equity without increasing overhead to the point that it’s not affordable or comfortable for you, that’s a good reason.”
For those looking to put their equity to work, renovations are typically regarded as one of the best vehicles.
Homeowners who qualify can use equity for several reasons. However, they are advised to exercise caution. One of the most popular uses of equity involves subsequent investments. Home equity can be used to invest for a higher return as long as interest rates remain low. If an opportunity presents itself, reinvesting your equity may be a great way to put your money to work for you.
“A HELOC or home equity loan can be an attractive way to finance a child’s education because the interest rate might be lower and the maximum loan amount higher than some other types of education financing,” says Andy Tilp, president of Trillium Valley Financial Planning in Sherwood, Oregon.
While some may disagree, the use of a home equity line of credit certainly has its place. However, there is a fine line in which dipping into equity represents a risk. The ease with which new debts can be accumulated suggests that using home equity to pay off previous debts is almost futile. Though popular, experts do not recommend paying off car loans, credit cards, or other personal debt. It may make sense when you run the numbers, but that doesn’t cure the problem of credit card debt. You want to make sure you are taking care of what got you into debt in the first place. Credit card debt is unsecured while a home loan is secured by your home, which explains why the interest rate is so much lower than a typical credit card rate. Essentially, freeing up unsecured debt for secured debt is a bad idea.
How To Borrow From Home Equity
With the economy on the mend, more homeowners have been awarded the opportunity of building up equity. As prices continue to rise, the use of equity may become more prominent. However, tapping into equity is not as easy as many may think, and not everyone meets the requirements to borrow from their “house bank.”
In order to take advantage of home equity, property owners must demonstrate that they have enough equity, a high credit score and a healthy debt-to-income ratio. Those with the appropriate credentials have a few different options for accessing home equity:
Home Equity Loan: A second mortgage for a fixed amount, at a fixed interest rate, to be repaid over a set period.
Home Equity Line of Credit: A second mortgage with a revolving balance, like a credit card, with an interest rate that varies with the prime rate.
Cash-Out Refinance: A mortgage refinance for more than the amount owed. The borrower takes the difference in cash.
It may go without saying, but you need equity to borrow from it. The amount of equity that you have established plays a significant role in whether or not you can tap into it. Lenders require a hefty amount of equity before homeowners can borrow against their homes. In general, a homeowner cashing out into a fixed-rate mortgage must have at least 15 percent equity left over, or a loan-to-value ratio of 85 percent, according to rules spelled out by Fannie Mae and Freddie Mac.
Once equity has been established, borrowers must meet certain credit score requirements. For HELOCs, most borrowers with a credit score between 660 and 680 will probably qualify, but a score of 700 is preferable. According to Fannie Mae’s standards, for cash-out refis, the lowest credit score on a home that the borrower lives in is 640. The ratio between a consumer’s total debt and income is also part of the qualification equation. And again, the lower the percentage, the better. The magic number, according to Fannie Mae and Freddie Mac, is 45 percent.
Equity is a word you will hear throughout your investing career, often in multiple different contexts. It can be used to measure a company’s financial health, asset type, or even investment portfolio. That’s why taking time to answer, “what is equity?” will be so beneficial as you break into the world of investing. Consider how building up equity in your portfolio could one day help you accomplish your financial goals.
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