What is Shareholders Equity?
Shareholders Equity is the difference between a company’s assets and liabilities and represents the remaining value if all assets were liquidated and outstanding debt obligations were settled.
Once all liabilities are taken care of in the hypothetical liquidation, the residual value – also referred to as the “book value of equity” – represents the remaining proceeds that could be distributed among shareholders.
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Under a hypothetical liquidation scenario in which all of a company’s liabilities are cleared off its books, the value that remains represents the “value” of the equity.
The fundamental accounting equation states that the total assets belonging to a company must always be equal to the sum of its total liabilities and shareholders’ equity.
- Assets: On the left side of the equation are the assets, which are resources that a company owns that can be sold for cash proceeds or can be used to produce cash flows.
- Liabilities & Equity: On the right side, the company’s liabilities and shareholders’ equity are listed, with each representing the funding sources used to purchase the assets.
If we re-formulate the balance sheet equation, we’re left with the shareholders’ equity being equal to the difference between total assets and total liabilities:
- Shareholders Equity = Total Assets – Total Liabilities
Otherwise, an alternative approach to calculate shareholders’ equity is to add up the following line items, which we’ll explain in more detail soon.
- Shareholders Equity = Paid-In Capital + Retained Earnings + Accumulated Other Comprehensive Income – Treasury Stock
There is a clear distinction between the book value of equity recorded on the balance sheet and the market value of equity according to the publicly traded stock market.
While the book value of equity is a historical measure recorded under accrual accounting, the market value of equity (i.e. market capitalization) is the pricing of the company’s shares as of the latest closing date of the markets.
The market value of equity is a byproduct of the current share price, as well as the total number of diluted shares outstanding. Hence, the market value of equity will typically be greater in comparison to the book value of equity.
Importance of Shareholders’ Equity
If shareholders’ equity is positive, that indicates the company has enough assets to cover its liabilities. But in the case that it’s negative, that means its debt and debt-like obligations outnumber its assets.
While there are exceptions – e.g. dividend recapitalizations – if a company’s shareholders’ equity remains negative and continues to trend downward, it is a sign that the company could soon face insolvency.
The shareholders’ equity line item on the balance sheet is composed of several items, with the main ones defined in the chart below:
|Common Stock & Additional Paid-In Capital (APIC)||
|Other Comprehensive Income (OCI)||
Common Stock and Additional Paid-In Capital (APIC)
Often referred to as paid-in capital, the “Common Stock” line item on the balance sheet consists of all contributions made by the company’s equity shareholders.
When companies issue shares of equity, the value recorded on the books is the par value (i.e. the face value) of the total outstanding shares (i.e. that have not been repurchased).
However, the issuance price of equity typically exceeds the par value, often by a substantial margin.
The excess value paid by the purchaser of the shares above the par value can be found in the “Additional Paid-In Capital (APIC)” line item.
As a standard modeling convention, APIC is typically coupled together with “Common Stock”.
Next, the “Retained Earnings” are the accumulated net profits (i.e. the “bottom line”) that the company held onto as opposed to paying dividends to shareholders.
For mature companies that have been consistently profitable, the retained earnings line item can contribute the highest percentage of shareholders’ equity. In these types of scenarios, the management team’s decision to add more to its cash reserves causes its cash balance to accumulate.
As a side benefit, the issuance of a dividend to shareholders can be perceived as a positive signal by the market that management is confident in the future profitability of the company, especially because dividends are rarely cut once announced.
In contrast, early-stage companies with a significant number of promising growth opportunities are far more likely to keep the cash (i.e. for reinvestments).
Retained Earnings Formula
To calculate the “Retained Earnings” line item, the equation consists of:
- Beginning of Period Retained Earnings
- (+) Net Income in Current Period
- (–) Shareholder Dividends Issued
- = End of Period Retained Earnings
The “Treasury Stock” line item refers to shares previously issued by the company that were later repurchased in the open market or directly from shareholders.
After the repurchase of the shares, ownership of the company’s equity returns to the issuer, which reduces the total outstanding share count (and net dilution).
Since repurchased shares can no longer trade in the markets, treasury stock must be deducted from shareholders’ equity. But an important distinction is that the decline in equity value occurs to the “book value of equity”, rather than the market value.
Share Buyback Trends
In recent years, more companies have been increasingly inclined to participate in share buyback programs rather than issuing dividends.
Another benefit of share buybacks is that such corporate actions can send out a positive signal to the market, much like dividends, without the obligation to maintain the repurchases (e.g. a one-time repurchase).
From the viewpoint of shareholders, treasury stock is a discretionary decision made by management to indirectly compensate equity holders.
The way in which equity holders benefit is that the earnings per share (EPS) increases from a lower share count, which can often lead to an “artificial” increase in the current share price (and market capitalization) upon a share repurchase.
Excel Template Download
Now that we’ve gone over the most frequent line items in the shareholders’ equity section on a balance sheet, we’ll create an example forecast model.
To follow along, download the Excel file using the form below:
In our modeling exercise, we’ll forecast the shareholders’ equity balance of a hypothetical company for fiscal years 2021 and 2022.
2020 End of Period Balances
- Common Stock & APIC: $100,000
- Retained Earnings: $500,000
- Treasury Stock: -$20,000
Considering the structure of roll-forward schedules – in which the ending balance of the current period is the beginning of period balance for the next year – the ending balances will link to the beginning balance cells.
Common Stock & APIC Assumptions
Our first roll-forward schedule will be for the “Common Stock & APIC” line item.
Here, we’ll assume $25,000 in new equity was raised from issuing 1,000 shares at $25.00 per share, but at a par value of $1.00.
The APIC, which represents the excess value above the par value, can be calculated using the formula below:
- Additional Paid-In Capital (2021) = $25,000 Total Capital Raised – $1,000 Common Shares @ $1.00 Par Value = $24,000
Retained Earnings Assumptions
In the next roll-forward projection, we’ll focus on the “Retained Earnings” balance,
Earlier, we were provided with the beginning of period balance of $500,000.
From the beginning balance, we’ll add the net income of $40,000 for the current period and then subtract the $2,500 in dividends distributed to common shareholders.
- Retained Earnings (2021) = $500,000 Prior Period Retained Earnings + $40,000 Net Income – $2,500 Common Dividends = $537,500
Treasury Stock Assumptions
As for the “Treasury Stock” line item, the roll-forward calculation consists of one single outflow – the repurchases made in the current period.
In 2021, the share repurchases are assumed to be $5,000, which will be subtracted from the beginning balance.
- Treasury Stock (2021) = -$20,000 – $5,000 = -$25,000
Note that the treasury stock line item is negative as a “contra-equity” account, meaning that it carries a debit balance and reduces the net amount of equity held.
Lastly, for the “Other Comprehensive Income (OCI)” line item, we’ll assume the amount remains constant at $5,000 for both 2021 and 2022 (i.e. assumption is straight-lined).
To arrive at the total shareholders’ equity balance for 2021, our first projection period, we add up each of the line items to get to $642,500.
If the same assumptions are applied for the next year, we get $700,000 for our end-of-period shareholders’ equity balance in 2022.