The Ultimate Guide to Equity

Equity is a term used in different contexts within business and investing, as well as in real estate and marketing.

There are different types of equity that represent various classes of ownership or metrics that measure how effective management is at running a business.

Understanding the value of equity and how it can be used strategically as a shareholder in a public company can empower your investment decisions. Here are the major points:

— What is equity?

— Why is equity important?

— How equity impacts investment decisions.

— Using equity as a tool for growth and profit.

[See: How to Keep Investing During a Recession]

What Is Equity?

Equity is the ownership of an asset. When you start allocating capital toward an asset, you are defined as its owner.

Equity is key to building long-term wealth and value, says Jeff Holzmann, CEO of IIRR Management Services, a crowdfunded real estate investment firm in New York.

Only with equity can your investments grow, says Holzmann. “As an equity investor, you gain or lose at the same ratio as the owners of the investment, company or property,” he says.

Debts and liabilities can be attached to an asset, impacting your equity. To get the liquid value of an asset, you must subtract liabilities from the value of the asset. This simple calculation can be reviewed in a variety of contexts where equity is used:

Equity = Assets – Liabilities

Companies in need of cash may require financing to meet short-term or long-term obligations, or to help fund a company’s growth. If a company requires more capital than it has on hand, it may turn to debt or equity financing.

An asset can be financed through debt, through which a company would take a loan that requires repayment with interest. Once that liability is paid in full, its obligation ends. In this scenario, the company’s equity is not impacted; it still retains full ownership of the asset.

Equity financing involves a company selling shares of the business in exchange for money. There is no repayment requirement, like with debt financing, but the company is giving away part of its ownership in exchange for cash.

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Why Is Equity Important?

Shareholder equity or stockholder equity consists of the assets of a firm minus the company’s liabilities. It establishes the value of common stock and preferred stock owned by investors. If the company were to liquidate, it would need to pay back the debt to its creditors first and then the remaining amount would go to shareholders.

Positive shareholder equity means a company has more assets than liabilities, which suggests the company is managing the business well. If a company’s balance sheet shows negative shareholder equity, this indicates liabilities exceed assets — and shareholders should take note.

A company that holds more debt than assets could mean it’s funding new projects that require large amounts of financing, or it may imply the financial status of the business is weak. This could also point to the company’s ineffective management.

A way to measure how well a company is using its assets is with the return on equity formula, a metric found by dividing a company’s net income by shareholder equity:

ROE = Net Income / Shareholder Equity

A high ROE points to the company using its equity efficiently, while a low ROE may indicate that the business is not managing its assets efficiently. ROE adds value when used to compare companies within the same industry.

Investors who want to increase their equity should look for companies that make consistent profits that exceed expenses, or invest more money in a company by buying more shares.

It’s important to increase your equity because “the more it grows, the larger the amount of value the company has created , and in the stock market that’s linked to an increase in the stock price,” says Mary D’Onofrio, vice president at Bessemer Venture Partners in Silicon Valley.

“In the public and the private markets, the equity that a company creates is generally tied to its ability to generate revenue and eventually cash flow,” she explains.

[See: Most Popular Robinhood Stocks.]

How Equity Impacts Investment Decisions

If you are a small-business owner or a startup in need of capital for growth, giving up some equity could be a strategic way to manage risk. Experts recommend proceeding with caution because this may come with a mix of positive and negative consequences.

“When you sell a piece of a company, you bring in monetary capital as well as intellectual capital — people who are strategic and can help guide you through missteps an early entrepreneur may face,” says Ari Rastegar, founder and CEO of Rastegar Property Co. in Austin, Texas.

The downside to trading in your equity is giving away too much in the early stages of the business, the most vital growth period for business, Rastegar says.

He recommends holding off on taking on too much money in exchange for a bigger-than-needed portion of equity.

“If you wait further along in the life of a business — as you ramp up your sales and grow the value of the company — you can trade more capital for less equity because the company would then be worth more,” he adds.

In the case of home equity, the home is the asset, the liability is the mortgage and the difference between the two is your equity.

For example, if a home’s purchase price is $200,000 and you have that exact amount of money to purchase the home outright, you have full 100% equity in that property. However, if you don’t have that large amount of cash on hand, you require loan financing in the form of a mortgage.

Say you need a $150,000 loan to purchase the home. Your equity would be the home price of $200,000 minus the loan amount of $150,000 and any other liabilities.

The money you hold in equity is yours. The more you pay down in your mortgage, the more equity you have in your home. Over time, your growth in home equity is how you build long-term wealth.

Growing home equity may impact a homeowner’s decision to make more mortgage payments to pay down the principal of the mortgage, which increases their equity and saves money on interest.

Rastegar recommends making an additional mortgage payment at the end of the year. So that’s 13 payments instead of 12. “That additional payment goes to paying down the principal of the loan,” he says.

Your home equity can also grow through property appreciation. If the value of your home grows over time, that contributes to your equity.

[READ: Fractional-Share Investing — Where to Invest.]

Using Equity as a Tool for Growth and Profit

Private equity is a segment of the market in which an investment firm puts up capital in exchange for ownership to invest in a company or groups of companies held in a portfolio or fund.

Private equity firms buy businesses that may be struggling or need a boost for expansion, build up the value of these companies by financing their growth for some time and then sell these companies for a huge profit.

That said, they don’t go at the investment alone; private equity firms partner with other investors such as hedge funds, pension funds and venture capital firms that gather money, which is the private equity that serves as leverage to get more capital in form of a loan from the bank to buy out a company.

After a few years, the investors sell the company for a profit to bring in a higher rate of return, pay back the bank loan with interest and split up the remaining amount among themselves.

Investors also turn to companies with strong brand equity, an intangible asset that adds qualitative value. Positive name recognition associated with a business — like Coca-Cola (ticker: KO), for example — can be a helpful driver of returns. The name of the company and the reputation it holds bring value to the products or services it offers and make consumers want to buy.

“As venture capitalists, we help our portfolio companies generate brand equity by enhancing their market presence with media opportunities, providing customer and investor introductions and even producing our own content,” D’Onofrio says.

Private equity values companies with positive brand equity because they can communicate with their consumers more effectively.

“When brand equity is high, you generally find that consumers (are more willing) to pay for a product or service that is otherwise at feature parity. That higher willingness to pay then drives higher sales and higher margins, enhancing profitability,” she adds.

The more consumers like the brand, the greater awareness they create for a company. Customer loyalty is a way to measure the quality and growth of brand equity.

Takeaway

For the do-it-yourself investor, equity serves as a way to grow wealth in your investments over time. Whether you’re a shareholder in a company, a startup founder, a homeowner or an investor in private equity indirectly through your pension, knowing which types of equity exist can help guide your investment decisions.

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The Ultimate Guide to Equity originally appeared on usnews.com

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