Shareholders' Equity

What is shareholders' equity?

Shareholders' equity is the net value owners could distribute among themselves if the company subtracted its liabilities from its assets. Also known as stockholders’ equity or book value of equity, a company amasses shareholders’ equity through investments or revenue generated over time.

Companies record their shareholders' equity on balance sheets. By looking at historical data, they can track whether this metric is trending positively or negatively. A positive trend indicates a healthy financial situation, whereas a negative trend shows difficulties.

Equity management software helps finance teams keep up with equity capitalization and maintain compliance. These tools also provide companies with the organized data necessary to make sound investment and growth decisions. 

Basic elements of shareholders' equity

Investors and business owners trying to maximize their shareholders’ equity must understand its key components first. These items, found on a company’s balance sheet, can be used to calculate shareholders’ equity.

• Share capital: Often called equity capital or paid-in capital, share capital is the money a company makes by selling common and preferred shares to investors. 
• Retained earnings: This is what remains after a company has paid out all fixed costs, variable costs, taxes, and dividends owed. Companies then reinvest this money to continue to expand their operations. 
• Treasury shares: Also known as treasury stock or reacquired stock, these are shares of stock the company has re-purchased from shareholders. 

Shareholders equity formulas

Companies can use two different methods to determine shareholders’ equity. Both formulas generate the same result so that companies can use them interchangeably. 

In this formula, the company first totals its liabilities or financial obligations, such as accounts payable and leases. Then, the company subtracts these from its total assets (i.e., any resources that generate cash or can be sold for cash). Assets include easily liquidated items, like inventory, and items that take longer to sell, like real estate. 

Also known as the investor’s formula, this formula takes a different route. Share capital is added to retained earnings (i.e., the profits remaining after the company paid costs and dividends to shareholders). Then, treasury shares are subtracted, revealing the shareholders’ equity. 

Importance of shareholders' equity

Shareholders’ equity is a line item on a balance sheet that reveals important information about a company’s financial standing. Investors and owners can gauge a company’s stability by analyzing how shareholders’ equity has increased or decreased over time. Other benefits of monitoring shareholders’ equity include:

• Guiding financial decisions. The formula considers the balance between assets and liabilities, which helps owners decide whether to take on more debt to grow the business or to reduce expenditures. For instance, if shareholders’ equity is negative, liabilities surpass assets, and owners may need to offload debt and cut costs. 
• Deciding to buy back shares. Keeping an eye on the shareholders’ equity metric helps owners choose whether to repurchase shares of their own stock to boost ownership value among existing shareholders. 
• Calculating return on equity (ROE). Investors use shareholders’ equity to calculate the ROE percentage. An indicator of a company’s profitability, ROE is found by dividing net income by total shareholders’ equity. If a company has a high ROE or one that’s increasing over time, it’s efficiently generating value from its assets for its shareholders.

Shareholders' equity vs. market capitalization

Shareholders’ equity and market capitalization are both ways of determining an organization’s value. However, the calculation process and the resulting value differ for each.

Shareholders’ equity, also known as book value of equity, is often seen as the equivalent of the “net worth” of an individual. It is the difference between assets and liabilities. Hypothetically speaking, if a company settled all of its debts and liquidated its assets, shareholders would each receive an equal portion of the money remaining. 

Market capitalization, also known as market cap or equity value, is the value of all outstanding common shares of a company. Investors often use the metric to gauge the size of a company.

To calculate market capitalization, the number of stock shares gets multiplied by the current share price. Market cap can vary depending on fluctuating share prices but often results in a higher value than shareholders’ equity. 

Shareholders’ equity and market capitalization both appear on a company’s annual report. Investors should look at both when sizing up whether a company is a worthwhile investment.