Small business equity and how to calculate it

Equity in business represents investors’ financial stake in a company. Investors earn partial ownership in the form of stock or shares by investing their money in a company. In this respect, equity ties into a business’s net worth and value in the eyes of investors.

After wrapping your head around equity, you still have to find a way to use it. Since there are many types of equity and more than one way to calculate their value, investors need to learn the ins and outs of leveraging investments. To help you do that, we'll break down the basics and help you make early investments with a huge ROI.

What is equity?

Equity is ownership of assets that may have liabilities or debts attached to them. These assets range from a house or car to an entire business. To have equity in something is to have a financial stake in something you helped fund. The more equity you buy in a business or asset, the greater your percentage of ownership. 

Why is equity important?

The value of a business's equity reflects its financial health. When a company shares income at a high cost, its assets and income exceed its losses and liabilities. In short, equity gives owners and investors a share of the profits. 

Investors who buy shares from a new business see the highest dividends since they pay the least early on. In return, they help fund the business. On top of dividends, shareholders get the right to vote on corporate actions and board of director elections.

Different types of equity

Equity and shareholders’ equity are often used interchangeably. Although they’re both important when discussing investments, they each paint a different part of the wider picture. 

• Equity is the percentage of ownership an investor has in a publicly traded company. In the case of a sole proprietorship or a small business, it is sometimes called owners’ equity. 
• Shareholders’ equity, sometimes called stockholders’ equity, is the difference between a company’s assets and liabilities as listed on its balance sheet. 

Types of equity in finance

There isn’t one answer to: “What is equity in finance?” Shareholder equity through common stock is far and away the most popular type of equity. However, investors can choose to invest in other equity types. The most common ones include: 

• Common stock: Securities representing a shareholder’s investment in, and partial ownership of, a business.
• Preferred shares: Stocks offering a guaranteed cumulative dividend instead of voting rights at a company.
• Contributed surplus: Also called additional paid-in capital, this is excess equity capital paid by investors when purchasing stock over the shares' par value.
• Retained earnings: Any business income not paid to stockholders as dividends.
• Treasury stock: Company shares bought back from stockholders.
• Other comprehensive income: Future income a company hasn't obtained yet.
• Warrants: Instruments that let investors purchase a particular stock at a predetermined price within a limited time frame.
• Risk capital: Money remaining after a liquidated business pays off its creditors.

Other types of equity

• Home equity: How much of a home an owner has paid off on their mortgage.
• Private equity: The evaluation of a company that isn’t publicly traded.
• Personal equity: The net worth of a person’s assets and liabilities.
• Brand equity: The value of a brand compared to generic or store-brand competitors.

The components of shareholder equity

You can gauge the value of company equity by subtracting liabilities from assets on its balance sheet in the general ledger. While this approach is simple, it ignores the core building blocks of an equity investment. The main pieces of equity include:

Outstanding shares

Outstanding shares represent the total stock issued to investors. In other words, outstanding shares make up all the stock a business has sold but not repurchased. Market experts use this figure to calculate earnings per share (EPS) and market capitalization.

The outstanding shares figure includes:

• Restricted shares that are harder to transfer
• The par value, or stated value of common stock set in a corporate charter
• The par value of preferred shares a business previously sold

Additional paid-in capital

Additional paid-in capital (APIC) is the amount spent on shares above the par value. To calculate APIC, subtract the stock's par value from the price each share sold for. Companies only earn APIC when investors buy shares directly from them. 

Investors consider APIC when weighing the cost of a share today versus its value during a company's initial public offering (IPO). Shares with higher APICs earned more value over time. You can find APIC in the equity section of a company's balance sheet.

Retained earnings

A business retains earnings when it holds on to income instead of paying it to shareholders. Some investors call retained earnings a retained surplus or the retention ratio. When retained earnings reach a positive balance on the balance sheet, businesses can reinvest them in the company or pay off debt.

Retained earnings make up a large portion of shareholder equity. In some cases, it's the biggest item on a balance sheet. Even though retained earnings lead to smaller dividends, they can promote a business's long-term health.

Treasury stock

Companies add to their treasure stock when repurchasing shares from investors. The treasury holds these equity stocks and retains them for future use. Businesses can sell this stock to raise capital or leverage it to prevent a hostile takeover. 

Balance sheets list treasury stock as a negative number. This is because treasury stock detracts from shareholders' total equity on the balance sheet. Analysts subtract treasury stock from a company's total equity because it leads to fewer purchasable shares until a business puts them back on the market.

How shareholder equity works

You can calculate shareholder equity’s value and a firm’s performance by subtracting what a company owes from what it owns. Businesses can issue equity by selling stock when they want to earn more capital. Investors buy shares to earn part of a company's profits, with the price of each share tied to a business's value. 

In short, equity binds investors and businesses together. Profitable companies pay large dividends, but their equity comes at a higher cost. Firms estimate the value of equity by subtracting liabilities from assets. A negative or positive result shows a company's financial health and equity value:

• If shareholder equity is positive, the business's assets cover its liabilities. Companies strive for positive equity because it means shareholders will receive a strong return on their investment from projected revenue. 
• If shareholder equity is negative, liabilities exceed a business's assets. A long-lasting negative balance will lead to insolvency and a sharp drop in share value.

What is a good return on equity?

Businesses generally shoot for a return on equity (ROE) between 15-20%. However, ROE isn't a measure of overall success. Instead, investors should use it to assess management's ability to generate income or compare two businesses in the same field.

You can calculate return on equity by dividing net income by total shareholder equity. ROE measures how well a company uses its assets to generate profit. As a result, ROE is often called the return on net assets or the amount of profit created from owner’s equity. 

How to calculate equity value

Equity value refers to the overall value of a company's shares and loans stockholders issue to the business. In general, you can calculate equity value using one of two formulas:

• Book value: Equity = Assets - liabilities
• Market value: Equity = share prices X the number of shares

Because each equity formula provides a different result, market analysts consider book value and market value in different contexts. Depending on the circumstances, you may prefer one metric over the other. However, savvy investors always keep both in mind. 

Whether you need to calculate book or market value, QuickBooks’ accounting software will offer fast, accurate results. 

Book value example

Equity's book value comes from a firm's financial statements and balance sheets. It’s the most common type of equity in accounting. Accountants use book value to derive worth from measurable assets and liabilities. For this reason, some analysts consider it more objective. However, book value relies only on past data, not future projections. 

For an example of book value, consider a restaurant. Its assets, including money, inventory, equipment, prepaid expenses, and intangible assets equal one million dollars. Its liabilities include lines of credit, debt, deferred revenue, leases, and other commitments worth 800 thousand dollars. In this case, the formula is:

• $1,00,000-$800,000= a book value of $200,000

Market value example

Equity's market value reflects the amount investors will pay for shares. Accountants consider it less objective because circumstances can affect the result, making it higher or lower than the book value. However, since market value weighs financial forecasting and market estimates, it's useful to investors planning ahead. 

For a publicly traded company, market value is easy to calculate. Assume an investment firm sold its latest share for $5,000. Additionally, suppose this company has 1,000 outstanding shares. In this case, you calculate the market value as:

• $5,000 X 1,000 = a market value of $5,000,000

If a company is private, you may not have the data for this equity equation. For the best results, hire an investment banker or accounting firm to analyze a company's past transactions, cash flow, and competitors' market value. Different experts may not come to the same conclusion, so don’t be afraid to get a second opinion.

How to leverage your equity: 3 best practices

Many investors focus on buying equity from a healthy company. While establishing yourself as a shareholder is important, the best investors know how to use their stock. By taking advantage of the tools given to shareholders, you can increase the return on your investment. 

Assess your company’s financial health

Shareholders gain access to a company’s balance sheet and financial records. Even if you trust the firm’s leadership, never assume your investment will take care of itself. By keeping your finger on the pulse of a business’s cash flow, you can prepare for market spikes and drops. For the best results, follow these steps:

1. Obtain updated financial information whenever you can.
2. Share your investment’s market data with an investment banker or market analyst. Ask them about the performance of your investment and how upcoming changes may affect it.
3. If your investment shares face a critical drop in value, consider selling them. 
4. If you want to hold on to your investment, present any issues you notice at the next shareholder meeting. 
5. Work with company leadership and vote on actions that improve your investment’s performance. 

Make wise voting decisions

Shareholders get to vote in corporate elections and set a business’s goals, with the value of their vote proportional to their number of shares. Wise investors use their voting power at both special elections and annual meetings. As a shareholder, vote on all issues that affect the health of the company and your investment:

• Corporate actions
• Business policy
• Board of directors members 
• Emergency issues

Remember to research the issues your company faces before casting a ballot. No two businesses share the same structure, so tailor your approach to the firm. To make the process easier, shareholders don't need to attend in-person elections. Instead, you can send a proxy to vote for you at meetings. 

Reinvest your dividends

Many investors choose to live off of their stock earnings. Even though you should enjoy the benefits of your equity shares, reinvesting your dividends pays off the most over time. For the best results, you can:

• Reinvest in the same company: Reinvesting in a business you already own shares in is fast and easy. On top of that, you avoid commission fees and have access to fractional shares. For the best results, sign up for a dividend reinvestment plan (DRIP) to buy more shares every pay period.
• Reinvest your money in a new company: Buying shares in different companies creates a more diverse portfolio. Diverse investments can withstand more market destabilization over time. For suggestions and viable equity examples, consult a broker or financial manager.

Accurate reporting = accurate decision-making

Shareholder equity offers a reliable income stream and plenty of investment opportunities. However, anyone looking to leverage their equity needs accurate reporting on their shares’ value and other stock opportunities. That way, you can measure profitability for long-term growth and a higher ROI. 

For an in-depth assessment of your equity's financial health, try QuickBooks business reporting features today.