Luisa Rollenhagen is a journalist and investor who writes about financial planning for Wealthsimple. She is a past winner of the David James Burrell Prize for journalistic achievement and her work has been published in GQ Magazine and BuzzFeed. Luisa earned her M.A. in Journalism at New York University and is now based in Berlin, Germany.
A helpful way to think about equity is to imagine you want to sell something you own, like a diamond necklace. The amount of money you would receive for that necklace, which would roughly equate to the necklace’s original value and any appreciated value minus any repair costs and depreciation from wear and tear, would basically be the equity of the necklace.
But while equity, in its most basic sense, refers to any monetary value tied up into an asset, it’s usually used in reference to real estate or stocks. For our purposes, equity represents the amount of money that a shareholder (i.e., you) would receive if a company’s assets were liquidated and all debt were paid off. However, there are many other sectors in which equity plays a crucial factor in determining value.Wealthsimple Invest is an automated way to grow your money like the world's most sophisticated investors. Get started and we'll build you a personalized investment portfolio in a matter of minutes.
Equity in different sectors
As mentioned before, equity doesn’t just refer to stocks and shareholders; it’s a concept that has a wide range of applications, basically in any area that has anything to do with money and value. Here are some sectors in which equity plays an important role:
Equity in stocks
In the financial world, equity in stocks is one of the determining factors that an investor considers when choosing an investment strategy, goals, and approach. Equity in stocks simply refers to the monetary value that the stocks have for the shareholder, meaning how much money the shareholder would get if the shares of a company were liquidated and all the company’s debt were paid off. Equity doesn’t just represent the initial value of the share when you purchased it; it represents the accumulated value after the stock price appreciated and the company kept growing. This type of equity is also known as shareholder’s equity.
Equity in accounting
In accounting, equity is usually referred to as the “book value.” This means that a company’s value is determined by the difference between the value of the assets and the value of the liabilities of something owned.
While shareholder’s equity takes a company’s stock price into account, an accountant would look at a company’s balance sheet that evaluates its current assets and then subtract the so-called liabilities, which can include debt, lines of credit, and value depreciation.
Personal equity (net worth)
Personal equity refers to the total sum of assets an individual person has, which are often made up of a combination of savings, investments, real estate, and cash income. Factors that lower your personal equity are things like debt, outstanding bills, and mortgages.
Equity in real estate
Investing in real estate (by buying a house, for example) can be a great way to build up equity. But when it comes to equity in real estate, the same principle applies: you have to consider both the inherent value of the asset, as well as the factors that could bring your asset’s value down. In real estate, that means that you can’t just look at a house’s market value in order to determine equity; you also need to consider the size of your mortgage, which will count against the property’s value.
Let’s say you own a house that’s worth $300,000, but you owe $150,000 on your mortgage. That means that your equity is $150,000. It’s also worth noting that every payment you make toward your mortgage helps you build equity, as do home improvements or anything that helps raise the property’s market value.
Have you ever stood in a supermarket aisle and looked at all the varieties of, say, cola, before grabbing the one you’re most familiar with? Then you’ve helped build brand equity. This kind of equity refers to the value that is generated from a product with a recognizable name. Brands like Apple, Coca-Cola, and Nike are instantly recognizable names whose products usually enjoy a broad and loyal customer base in part because of the brand slapped onto it.
Return on equity formula
So what’s the whole point in determining equity? Well, it can be an incredibly useful metric in determining a company’s performance, its financial health, and how it uses its resources. And because we’re talking about finance here, there’s a formula for the whole thing. It’s called the return on equity (ROE) formula, which calculates a company’s return on net assets—basically, determining how effectively a company is using its assets to generate profit.
ROE is calculated in the following way:
Return on equity (expressed as a percentage) = net income / average shareholder’s equity
In this formula, net income refers to the amount of income a company generates for a given period, after all expenses have been deducted. Shareholder’s equity, as you’ll recall, refers to the market value of a company.
What this formula tells you is how effectively a company uses its resources. Let’s say that in 2019, company Snufflepuff Inc. has reported $1.6 million in net income. The average shareholder’s equity comes out to $12 million. This means that Snufflepuff Inc.’s ROE would be 13%. Broadly speaking, what’s considered a good or a bad ROE depends on the average of the industry in which the company operates, but a safe bet is to look at the S&P 500’s long-term ROE average, which is 14%, and then go off of that. Usually, any ROE of less than 10% should raise an eyebrow or two.
ROE is a helpful measurement in determining a company’s effective use of resources, but it can also be used to identify whether a company is borrowing excessively (indicated by an artificially high ROE) or experiencing inconsistent profits. Either way, a negative ROE is usually bad news.
If you’ll recall, equity, in all of its forms, is basically a simple equation that subtracts liabilities such as debt from the total value of the assets in question. So let’s put that into practice:
Let’s go back to company Snufflepuff Inc., which produces a wide range of popular products that have significantly raised the total value of its assets. Let’s say Snufflepuff Inc. has assets worth $60 million in total, but it’s also carrying some significant long-term debt and some outstanding tax payments that amount to $20 million. This means that Snufflepuff Inc. has a shareholder’s equity of $40 million.
So theoretically, if Snufflepuff Inc. were to liquidate all of its assets, the company’s shareholders would receive $40 million .
Why equity matters
Equity represents the value you’re holding in a particular asset or company. While you, as an investor, might be concerned with your personal equity in a company,—which represents how much you, personally, would get if a company liquidated its assets—looking at the total shareholder’s equity can give you a good idea of the company’s financial health.
The same goes for other kinds of equity, whether that be real estate equity or personal equity. It’s useful to know how much your house would be worth if you put it on the market right now, or what your personal financial foundation looks like. It can also help you determine whether any changes need to be made, from readjusting your investment portfolio, paying off high-interest debt, or creating a more efficient savings strategy.
And while equity alone is not a definitive indicator of a company’s or an individual’s financial health, it’s a tool that, when used with other metrics, can help give you a better overall financial picture of your investment targets, whether that be buying shares of Snufflepuff Inc., taking on a renovation project for your new house, or opening a retirement account.
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