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.
How to Calculate Shareholders Equity (Step-by-Step)
Shareholders’ equity is defined as the residual claims on the company’s assets belonging to the company’s owners once all liabilities have been paid down.
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.
Shareholders Equity Formula
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:
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: Book Value vs. Market Value
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 recapitalization – if a company’s shareholders’ equity remains negative and continues to trend downward, it is a sign that the company could soon face insolvency.
Shareholders’ Equity Components
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 and 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.
Stock Buyback: Corporate Share Repurchase 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.