Equity, also known as shareholder equity, refers to the value that would be returned to a company's shareholders if all its assets were liquidated, and its debts fully repaid. It is an essential indicator of a company’s financial health and is presented on the company’s balance sheet. Investors often rely on this metric to assess the soundness of a company’s financial position.
Features of equity
Feature |
Description |
Ownership stake |
Equity represents an ownership share in a company, giving the shareholder partial ownership of the business. |
Return on Investment (ROI) |
Investors expect returns in the form of capital appreciation or dividends. If the company performs well, the value of equity rises, resulting in potential profits. |
Residual claim |
In case of liquidation, equity holders are paid after all debts and obligations are settled. They have a claim on the remaining assets. |
Risk and reward |
Equity investments carry risks but also offer potential for higher rewards if the company succeeds. |
Voting rights |
Common stockholders usually have voting rights, allowing them to influence major company decisions, such as electing directors. |
Liquidity |
Equity has no fixed repayment schedule. Shares can be sold on the stock market, offering liquidity, but the value is subject to market fluctuations. |
Dividends |
Some companies distribute profits as dividends, providing shareholders with a periodic income. Not all companies, however, pay dividends. |
Balance sheet entry |
Equity is recorded on the company’s balance sheet, helping investors gauge the financial health and stability of the business. |
Equity shares formula
The formula to calculate shareholder equity is:
Shareholders' Equity = Total Assets - Total Liabilities
To compute equity:
- Locate the total assets on the company’s balance sheet for the specific period.
- Identify the total liabilities, listed separately on the balance sheet.
- Subtract total liabilities from total assets to find the shareholder equity.
It is noteworthy that total assets always equal the sum of total liabilities and total equity. While some methods consider shareholder equity as the difference between share capital and retained earnings (minus treasury shares), calculating based on assets and liabilities offers a clearer view of financial health.
Types of equity investments
- Shares:
Shares are the most common form of equity investment. When you purchase shares of a company, you acquire ownership in that company proportional to the number of shares you own. As a shareholder, you have the potential to benefit from capital appreciation—when the company's stock price rises—as well as dividend payments, which are a portion of the company's profits distributed to shareholders. - Equity mutual fund investments:
Equity mutual funds pool money from multiple investors to invest in a diversified portfolio of stocks. Professional fund managers manage these funds, selecting a mix of stocks across different sectors and industries. Investing in equity mutual funds provides diversification and professional management, making it an attractive option for those who want exposure to the stock market without directly purchasing individual stocks. - Equity futures:
Equity futures are contracts that obligate the buyer to purchase, and the seller to sell, a predetermined number of shares of a specific company's stock at a set price on a future date. Futures allow investors to speculate on the future direction of stock prices and can be used for hedging against potential losses in the equity market. - Equity options:
Equity options are contracts that give investors the right, but not the obligation, to buy or sell shares of a company's stock at a predetermined price within a specified timeframe. Call options allow investors to buy shares at a fixed price, while put options allow investors to sell shares at a predetermined price. Options provide flexibility for various investment strategies, including hedging, income generation, and leveraging.
How shareholder equity works?
Shareholder equity reflects the ownership and potential returns from investing in a company’s stocks. Here’s how it functions:
- Investors earn profits through capital gains (an increase in share prices) or stock price appreciation.
- Shareholders often receive voting rights on corporate matters like electing board members.
- Although equity investments offer the potential for high returns, they come with inherent risks. It’s essential for investors to assess their risk tolerance before investing in equities.
Advantages of investing in equity shares
1. High returns
Equities provide significant returns through dividends and capital appreciation.
2. Cushion against inflation
Equity investments often yield returns that outpace inflation, preserving and enhancing the investor’s purchasing power.
3. Ease of investment
Investing is straightforward, with options to use stockbrokers or financial planners. With a Demat account, stocks can be purchased in minutes.
4. Diversification
Adding equities to a portfolio diversifies it beyond low-risk instruments like debt, offering higher potential returns.
Disadvantages of investing in equities
1. High market risk
Equity investments are subject to significant risks, and investors can lose their entire investment corpus in adverse market conditions.
2. Performance-related risks
Equities are market-dependent and may not perform as expected due to sectoral or broader market trends.
3. Inflation risk
Rising inflation can erode a company’s value, reducing the returns on its shares.
4. Liquidity risk
Investors may have to sell shares at a lower price during liquidity crunches, impacting returns.
5. Social and political risks
Changes in government policies or social unrest can affect business growth and, consequently, equity returns.
Getting started with equity investing: Opening a Demat account
Before diving into equity investing, it's important to open a Demat (Dematerialized) account. A Demat account holds your equity investments in an electronic format, eliminating the need for physical share certificates. It offers ease of trading, tracking, and managing your equity portfolio.
Conclusion
Equities serve as a cornerstone of investment portfolios, offering opportunities for growth and wealth accumulation. As an equity investor, you become a part-owner of companies, sharing in their successes and challenges. Whether you choose to invest directly in individual stocks, opt for equity mutual funds, or explore derivative instruments like futures and options, equities can be a powerful tool for building wealth over time. It's important, however, to carefully consider your risk tolerance, investment horizon, and financial goals before diving into the world of equities. A well-informed and balanced approach can help you harness the advantages of equity investing while managing its inherent risks.
