Have you ever heard the term equity used in so many different contexts and confused its meaning? If you are going to invest your hard-earned dollars we need to understand what equity is. Equity is one of the primary reasons why wealthy people are in the position they are today.
Equity is an ownership claim to a business’s assets after deducting all of its liabilities. It is also the amount of capital that was contributed to the business in addition to par value, plus any retained earnings. Simply put, if a company issues 100 shares and I own 10 of them, I own 10% of the outstanding equity of the company. Ok, so why do we care about equity?
Most wealthy individuals do not hold all their wealth in cash. In fact, many only hold a mere fraction of their net worth in cash or cash equivalents. They generally want their assets to grow over time. Holding cash will actually lower their earning power over time due to inflation. People will buy equities (another term for stocks,) real estate, bonds, art, commodities or many other forms of investments to increase their net worth, hopefully faster than inflation. With equity, we look for companies or other investements that will increase earnings over time. As the earnings increase, the value of the company will increase.
So what is equity? First the most familiar, real estate.
This form of equity represents the value of your property minus the amount of your mortgage. As you pay down your mortgage your equity interest in you property goes up. Should you sell your property, you will receive the funds for the sale price of the home minus any outstanding mortgages or loans against the property after all closing costs are removed.
You might have heard of a home equity line of credit. Essentially you are borrowing money with your equity stake in your home used as collateral. During the last real estate bubble, there were plenty of people who were financing a large house remodel or buying cars by tapping into the inflated value of their primary residence. When the housing market tanked the value of their home equity in some cases went negative. In TPMoney’s experience, we generally don’t like using our home as a piggy bank and recommend against doing this in most cases. Then again, we really don’t like any form of debt.
Public equity is traded on public exchanges though stock certificates. A single share of stock is a claim on the assets and liabilities of a publicly traded company. These shares are traded daily. Well known companies like Disney are extremely liquid with high volumes of shares trading hands every day. This volume is attractive because it increases the liquidity of the investment. If the company trades on over the counter exchanges it may be highly illiquid.
Companies that issue public equity go through an Initial Public Offering (IPO.) After the IPO, there may be secondary offerings if the company needs to raise more capital to expand operations, make an acquisition or finance working capital.
Many large public companies distribute earnings in the form of dividends to share holders. For instance Disney paid two dividends over the course of 2016 for a total of $1.49 per share in 2016.
Private Equity is very similar to public equity, only that it is generally held by fewer individuals, is not traded on public markets and is much more illiquid. Obtaining shares in private companies can be very lucrative, especially if they are early stage, fast growth companies. You may have heard stories of angle investors or venture capital firms that made a bundle by investing very early in companies like Uber. After the IPO (initial public offering) financing event the insiders and major shareholders of the company finally liquidate some of their equity and diversify.
Alternatively, maybe your family has had a family owned business and you were gifted shares of the company.
There are also private equity firms that specialize in taking public companies private for a time. Generally they do so to leverage the company. Later they will sell the company or take if public again for a profit.
Stock Holders Equity
Stockholders equity on the other hand is a section on the balance sheet of a companies financial statement. The stockholders equity is usually broken up into three sections. This part might make your eyes glaze over so bear with me:
- Par Value is really the value printed on the stock certificate. We really don’t care much for going into further detail on this as it provides very little use for security analysis
- Additional Paid in Capital is just as it sounds. It is the amount of money the company raised during the offering over and above the par value of the stock certificates
- Retained Earnings are the earnings accumulation of the company over time. When a company has surplus capital on their hands, they may send the shareholders a dividend, buy back shares or simply retain the funds to use later or pay down debt. Retained earnings is the amount capital the company has retained. Too make this even more confusing, sometimes a company will buy back it’s already issued stock. This will show up as treasury stock and effects retained earnings by lowering the number of shares the company needs to pay dividends on.
You might have heard me mention liquidity. All equity is not created equal. When investing in equity, whether stocks, private businesses or real estate; liquidity of the investment needs to be considered. Some stocks trade on very high volumes, like Coca Cola. Other stocks trade on over-the-counter markets with very low volume. It might take a long time to find a buyer for your shares. Ownership in private businesses or real estate may take even longer.
We like Equity!
Adding equity in the form of real estate investments or by purchasing stock either directly or through an index fund is a great way to increase your net worth over time and achieve financial independence. The more you can add to your portfolio’s the better, always at appropriate valuations of course and making sure you are appropriately diversified.
Your equity ownership will drive larger and larger amounts of passive income for you to spend or reinvest in more equity. The passive income from stock will come from dividends, if your selected public equity decides to declare one. Passive income from equity ownership of rental properties come in the form of rent checks. After covering your expenses, what is left over is yours to do as you please.