What is Equity?
In finance and accounting, equity is the value attributable to the owners of a business. The book value of equity is calculated as the difference between assets and liabilities on the company’s balance sheet, while the market value of equity is based on the current share price (if public) or a value that is determined by investors or valuation professionals. The account can also be called shareholders/owners/stockholders equity or net worth.
There are generally two types of equity:
- Book value
- Market value
#1 Book value of equity
In accounting, equity is always listed at its book value. It is the value that accountants determine by preparing financial statements and the balance sheet equation that assets = liabilities + equity. The equation is rearranged to be equity = assets – liabilities.
The value of a company’s assets is the sum of each current and non-current assets on the balance sheet. The main accounts include cash, accounts receivable, inventory, prepaid expenses, fixed assets, property plant and equipment (PP&E), goodwill, intellectual property, and intangible assets.
The value of liabilities is the sum of each current and non-current liability on the balance sheet. Common accounts include lines of credit, accounts payable, short-term debt, deferred revenue, long-term debt, capital leases, and any fixed financial commitment.
In reality, the value of equity is calculated in a much more detailed way, and is a function of the following accounts:
- Share capital
- Contributed surplus
- Retained earnings
- Net income (loss)
To fully calculate the value, accountants must track all capital the company raised and repurchased (its share capital), as well as its retained earnings, which consist of cumulative net income minus cumulative dividends. The sum of share capital and retained earnings is equal to equity.
#2 Market value of equity
In finance, equity is typically expressed as a market value, which may be materially higher or lower than the book value. The reason for this difference is that accounting statements are backward looking (all results are from the past) while financial analysts look forward into the future to forecast what they believe financial performance will be.
If a company is publicly traded, the market value of its equity will be easy to calculate, it’s simply the latest share price multiplied by the total number of shares outstanding.
If a company is private, it’s much harder to determine its market value. If the company needs to be formally valued, it will often hire professionals such as investment bankers, accounting firms (valuations group), or boutique valuation firms to perform a thorough analysis.
Estimating market value of equity
If a company is private, the market value must be estimated. It is a very subjective process, and two different professionals can arrive at dramatically different values for the same business.
The most common methods to estimate equity value are:
In the discounted cash flow approach, an analyst will forecast all future free cash flow for a business and discount it back to the present using a discount rate (such as the weighted average cost of capital). It is a very detailed form of valuation and requires access to significant amounts of company information. It is also the most heavily relied on approach, as it incorporates all aspects of a business.
To learn more, read CFI’s guide to business valuation resources.
Personal equity (Net worth)
The concept of equity applies to individual people as much as it does to businesses. We all have our own personal net worth, and a variety of assets and liabilities we can use to calculate the net worth.
Common examples of personal assets include:
- Real estate
- Furniture and household items
- Cars and vehicles
Common examples of personal liabilities include:
- Credit card debt
- Lines of credit
- Outstanding bills (phone, electric, water, etc.)
- Student loans
The difference between all these assets and all these liabilities is your personal net worth.
Example in Excel
Let’s look at an example of two different approaches in Excel. The first is the accounting approach, which determines the book value, and the second is the finance approach, which estimates the market value.
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As you can see, the first method takes the difference between the assets and liabilities on the balance sheet and arrives at a value of $70,000. In the second method, an analyst builds a DCF model and calculates the net present value (NPV) of the free cash flow to the firm (FCFF) as being $150,000. This gives us the enterprise value of the firm (EV) which has cash added to it and debt deducted from it to arrive at the equity value of $155,000.
It is very common for this market approach to produce a higher value than the book value.
Thank you for reading this guide to understanding what equity is and how it works.
CFI is the official global provider of the Financial Modeling & Valuation Analyst (FMVA)TM certification program designed to transform anyone into a world-class financial analyst. To continue advancing your career, these additional resources will be helpful: