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Finance guide: shareholders' equity (definition, formulas, examples)
Understanding the foundation of shareholders’ equity.
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1 minute
September 27, 2024
Isabel Peña Alfaro is a guest contributor. The views expressed are hers and do not necessarily reflect the views of Rho.
Wondering what shareholder equity will tell you about a startup? You’re in the right place. In this guide, we’ll go over what shareholder equity is, its components, calculation, and examples, and we’ll discuss how stock buybacks affect shareholder equity.
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Shareholder equity (SE), also known as shareholders’ equity, stockholders' equity, or owners' equity, represents the residual value of a company's assets after subtracting all its liabilities. Essentially, it shows the net worth of a company from the shareholders' perspective.
SE provides a full snapshot of a company's financial health and performance, and it indicates the company’s financial stability.
It serves as a fundamental indicator of a company's financial position, operational efficiency, and potential for future growth, making it an essential metric for investors, analysts, and company management.
Essentially, SE is a specific form of net worth tailored to corporate entities, whereas net worth is a broader term applicable to various financial contexts.
Let’s break it down further.
SE is the net worth of a corporation from the perspective of its owners (shareholders). It's what would be left for the shareholders if the company were to sell all its assets and pay off all its debts.
Net worth, on the other hand, is a more generic term that can apply to both individuals and businesses, representing the total value of assets minus liabilities.
While SE is used primarily in the context of companies with multiple owners or shareholders, net worth can be used to describe the financial health of an individual or a sole proprietorship without distinguishing between different types of equity holders.
We’ll dive into the formulas for some of these terms later in this guide. For now, let’s go over what each of these components means.
Common stock represents ownership shares in a corporation and is the most prevalent form of stock issued to investors. It grants shareholders voting rights in corporate decisions, typically one vote per share, allowing them to elect board members and influence company policies.
Common stockholders have a claim on the company's profits through dividends, although these are not guaranteed and are paid at the discretion of the board of directors.
Additional paid-in capital (APIC) is the amount of money investors pay for a company's stock above its par value. In other words, it represents the excess of the issue price over the nominal or par value of the shares. APIC is created when a company issues new shares, either during an initial public offering (IPO) or in subsequent offerings.
APIC benefits the company by providing additional funds without incurring debt, but it doesn't give individual investors any additional shares or power beyond their total investment purchases.
Preferred stocks and preferred shares refer to the same thing—they are interchangeable terms.
Preferred stock is a unique form of company ownership that combines elements of both stocks and bonds. Unlike common stock, preferred shares typically offer fixed dividend payments that are paid out before dividends to common shareholders. This provides more stable and predictable income, making preferred stocks attractive to investors focused on regular payouts.
Preferred stockholders have a higher claim on the company's total assets and earnings compared to common stockholders, but rank below bondholders in priority.
Treasury stock refers to shares that were once part of the outstanding shares of a company but were subsequently repurchased by the company itself. These shares are held in the company's treasury and can be reissued or retired at a later date.
Treasury stock does not carry voting rights, nor does it receive dividends, and it is not included in the calculation of earnings per share (EPS).
Retained earnings represent the cumulative net income of a corporation that has been retained rather than distributed to shareholders as dividends. These earnings are reinvested in the business to expand operations, purchase new equipment, or pay off debt.
An accumulated deficit, also known as a retained earnings deficit or accumulated loss, occurs when a company's cumulative losses and dividend payments exceed its cumulative profits.
This negative balance indicates that the company has not been profitable over time and may signal financial instability or potential bankruptcy if the company cannot generate sufficient profits to offset the deficit.
Other Comprehensive Income (OCI) consists of revenues, expenses, gains, and losses that have not yet been realized and are excluded from net income on the income statement according to Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS).
Common OCI components include unrealized gains and losses on investments, foreign currency translation adjustments, and changes in the value of pension plans. OCI provides a broader view of a company's financial performance. OCI allows stakeholders to better assess the company's overall financial health and performance.
Investors, financial analysts, and company management use the statement of SE to assess changes in equity over a reporting period, evaluate financial health, and make informed decisions about investments and corporate strategies.
Let’s go over the benefits of the statement of SE and its structure.
Creating and using statements of SE is essential for providing a transparent and detailed account of changes in equity over a reporting period.
This helps stakeholders understand how profits are retained, dividends are distributed, and equity capital is managed, thereby facilitating informed investment and management decisions.
The structure of the statement of SE typically includes these key components: beginning equity balances, additions and subtractions to equity, and ending equity balances.
In other words, the statement of SE provides a thorough view of how equity has evolved over the reporting period, offering transparency into transactions (e.g. stock issuance, repurchase, dividend payments, and other adjustments) affecting SE.
To calculate shareholders' equity, you can use the following formula:
Shareholders’ Equity = Total Assets − Total Liabilities
Another calculation is:
Shareholders’ Equity = Common Shares + Preferred Shares + Paid-In Capital + Retained Earnings
These formulas are not contradictory, but rather complementary.
Here's why:
The first formula (Assets - Liabilities) calculates SE as a residual value. It represents what's left for shareholders after all company debts are paid. The second formula (Common Shares + Preferred Shares + Paid-In Capital + Retained Earnings) breaks down the components that make up SE, showing its sources of funding and accumulated profits.
Now, we’re going to review the components for the formulas (assets, liabilities, common shares, preferred shares, paid-in-capital, and retained earnings).
First, we’ll go over the components of the first formula (Assets - Liabilities).
Current and long-term assets are two main categories on a company's balance sheet.
Let’s go over each of them.
To summarize, their key differences include:
Current liabilities
Current liabilities are a company's short-term financial obligations that are due within one year or within a normal operating cycle, whichever is longer. Current liabilities are key for assessing a company's short-term liquidity and its ability to meet immediate financial obligations.
These liabilities are typically settled using current assets. Common examples include accounts payable, short-term loans, dividends payable, notes payable, the current portion of long-term debt, accrued expenses, and income taxes payable.
Long-term liabilities
Long-term liabilities, also known as non-current liabilities, are financial obligations that are due beyond one year or the normal operating cycle of the company. These liabilities are used to finance long-term investments and operations, such as purchasing property, plant, and equipment.
Next, we’re going to go over the components of the second formula (Common Shares + Preferred Shares + Paid-In Capital + Retained Earnings).
The common shares are the total issued shares minus the treasury stock.
Common Shares = Total Issued Shares - Treasury Stock
The number of preferred shares is usually disclosed in the company's financial statements under the equity section. If it’s not directly available, you might find it in the notes of the financial statements.
Paid-in capital, also known as contributed capital, represents the total amount of money that a company has received from investors in exchange for its stock. This includes both the par value of the issued shares and any amounts paid over the par value (the APIC).
Paid In Capital = Par Value of Common Stock + Additional Paid In Capital
Another calculation is:
Paid In Capital = Total Number of Shares Issued × Issuance Price Per Share
The formula for calculating retained earnings is:
Retained Earnings = Beginning Retained Earnings + Net Income or Loss − Dividends Paid
Additional metrics that use SE include debt-to-equity ratio (D/E), return on equity (ROE), return on average equity (ROAE), and the book value of equity per share (BVPS).
Let’s go over how each of these specifically employs shareholders’ equity.
In all these metrics, changes in SE can significantly impact the results, affecting how investors and analysts interpret a company's financial health, profitability, and valuation.
The SE ratio measures the proportion of a company's total assets financed by SE (rather than debt).
The formula for shareholders’ equity ratio is:
Shareholders Equity Ratio = Shareholders’ Equity / Total Assets
A higher SE ratio indicates that a greater portion of the company's assets are financed by equity, suggesting lower financial risk and potentially greater financial stability.
Conversely, a lower ratio implies higher reliance on debt financing, which can increase financial risk.
Book value of equity (BVE) and Market value of equity (MVE) are two important metrics used to assess a company's value, but they approach this valuation from different perspectives.
BVE, also known as SE as mentioned earlier, represents the net value of a company's assets as recorded on its balance sheet. It is calculated by subtracting total liabilities from total assets.
BVE reflects the historical cost of a company's assets minus depreciation and liabilities, providing a snapshot of the company's accounting value. This metric is based on tangible assets and does not account for intangible factors like brand value, intellectual property, or future growth potential.
MVE, on the other hand, represents the total value of a company's outstanding shares in the stock market. It is calculated by multiplying the current stock price by the number of outstanding shares.
MVE is driven by investor sentiment, expectations of future earnings, and overall market conditions. As a result, MVE can differ significantly from BVE, especially for companies with strong brand recognition or high growth potential in industries like technology or pharmaceuticals.
Below we’ll go over a hypothetical example of SE.
Let’s assume that XYZ startup has the following:
Common Stock = Shares Outstanding x Par Value
Common Stock = 10,000 x $1 = $10,000
APIC = (Market Price - Par Value) x Shares Outstanding
APIC = ($20 - $1) x 10,000 = $190,000
Total Common Stock and APIC = $10,000 + $190,000 = $200,000
Now, let’s go over a retained earnings calculation example. The formula is: Beginning RE + Net Income - Dividends.
Ending Retained Earnings = Beginning RE + Net Income - Dividends
= $50,000 + $40,000 - $2,500
= $87,500
The treasury stock formula is:
Shares Repurchased x Repurchase Price
Treasury Stock = Shares Repurchased x Repurchase Price
= 500 x $18
= $9,000
Let’s take a look at Bank of America Corporation’s 2023 annual report.
Shareholders' Equity = Total Assets - Total Liabilities
Shareholders' Equity = $3,180,151 - $2,888,505
= $291,646
Stock buybacks, also known as share repurchases, involve a company purchasing its own outstanding shares from the market. This action directly impacts SE in several ways.
When a company buys back its shares, it reduces the number of shares outstanding, which can lead to an increase in EPS since the same amount of earnings is now distributed over fewer shares.
This often results in a higher stock price, benefiting remaining shareholders by increasing the value of their holdings. Additionally, buybacks can signal to the market that the company believes its shares are undervalued, which can further boost investor confidence and stock prices.
Note, however, that share buybacks reduce the company's cash reserves because the company taps its own cash reserves or takes on debt to repurchase its shares. So, this reduction in assets can decrease the overall SE on the balance sheet.
While the immediate effect of a buyback is a reduction in total equity due to the outflow of cash, the long-term impact can be positive if the buyback leads to a higher stock price and improved financial ratios, such as return on equity.
On the other side of the coin, critics argue that buybacks can sometimes be poorly timed or used to artificially inflate stock prices for executive compensation purposes, potentially leading to misallocation of resources and long-term financial instability.
The bottom line is that the effect of stock buybacks on shareholder equity depends on the company's execution and the broader financial context.
With the assets minus liabilities method, you can use this formula:
Stockholders' Equity = Total Assets - Total Liabilities
No, SE is not an asset. It represents the residual interest in the assets of a company after deducting liabilities. SE appears on the balance sheet alongside assets and liabilities.
The relationship between SE and dividends is that when a company pays out cash dividends, it reduces its SE by decreasing retained earnings, which is a component of equity.
Note that stock dividends, however, don't change the total shareholders’ equity; they just move value from retained earnings to paid-in capital within the equity section of the balance sheet.
The book value of equity is essentially the same as SE, representing the net worth of the company attributable to the company’s shareholders after deducting liabilities from assets.
To evaluate SE, you can:
These are some simple ways to evaluate SE.
While equity ownership offers potential for gains, it also comes with financial risks, limited control, and exposure to market forces that can negatively impact shareholders.
For instance, share prices may potentially decrease, the stock prices will be subject to market fluctuations, and public companies may face pressure to deliver short-term profits at the expense of long-term growth to satisfy shareholders. These are all risks that equity shareholders take.
The bottom line is that SE represents the remaining value of a company's assets after subtracting all its liabilities. SE offers insight into a company's financial position because it reflects its overall performance and indicates its long-term financial strength.
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Note: This content is for informational purposes only. It doesn't necessarily reflect the views of Rho and should not be construed as legal, tax, benefits, financial, accounting, or other advice. If you need specific advice for your business, please consult with an expert, as rules and regulations change regularly.