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 or a value that is determined by investors or valuation professionals.
The account may also be called shareholders/owners / stockholders equity or net worth.
In the context of stock market investments, equity refers to the shares in a company’s ownership. In simpler terms, it is the total amount of money that a shareholder is eligible to recieve if all of a company’s debts are paid off and its assets liquidated.
Examples of equity are:
1.Common Stock: Common stock represents the total number of shares multiplied by its par value.
2.Preferred Stock: Preferred stock is similar to common stock. However, they get precedence in dividend payments.
3.Additional Paid-in Capital:This is the amount over par value contributed by the shareholders.
4.Treasury Stock: Treasury stock shares that have been reacquired by the company from the shareholders
5.Retained Earnings: It is the portion of the income that is retained in the company to invest in the business.
Equity = Total Assets – Total Liabilities
Types of Equity
1. Book Value
The book value of equity mainly refers to the accounting perception of equity. This typically relates to the figure that accountants of a firm derive from balance sheet calculations. Therefore, book value deals with equity that is reflected on an organization’s financial statement.
Book value considers current and non-current assets and liabilities.
For example, a company’s assets are prepaid expenses, Cash and Inventory. It also includes accounts receivable, intangible assets and intellectual property.
Besides, book value also takes into account the current and non-current liabilities. These mainly involve credit, short-term and long-term debt, and other fixed financial obligations.
Book value = ( Total Common Shareholders Equity – Preferred Stock ) / Number of Outstanding Common Shares.
2. Market Value
Contrarily, the market value of equity implies the financial aspect of equity in the share market. However, market value of equities differs from book value as the former indicates the present value of equity in the market.
Besides, Market value is heavily influenced by the level of competition and information related to a company’s range of products. Typically, the method to calculate market value of equity involves the multiplication of trading price and number of shares.
Market value = latest share price × outstanding shares in the market.
What is the Market Value of Equity ?
The market value of Equity is the total market value of all the outstanding stock of a company. Here, the outstanding stock are the shares that are owned by the shareholders, investors, etc., of a company. Equity refers to the Assets of the company after the liabilities are paid. It is also known as Market capitalisation.
Therefore, the market value of equity is continuously changing as the two inputs keeps on changing. In a company, the market value of equity is different from the book value of equity, as a book value does not evaluate the company’s future potential growth.
Market value of equity is evaluated by multiplying the current market price per stock by the total number of the organization’s outstanding stocks.
Factors Affecting Market value of Equity:
1.Availability of New information
2.A number of Market contenders
1. Availability of New information: Any new updates in the company like its expansion, new products production affects the financial status of the company. Therefore it affects the price of the company’s share that eventually influences the market value of the company.
2. A number of Market contenders: The market becomes more comprehensive and competent if the number of investors, traders increases.
3. Government Interference: This point immensely interrupts the market value of the companies. In cases, where few countries prohibit foreign people to trade in their market. So, the market value of these companies in such a closed market cannot expend as compare to other open markets.
4. Circular Factors: Market value keeps fluctuation. Like in recession, the market decreases.
Market value of Equity vs Book value of Equity
The equity value of a company is not the same as its book value. It is calculated by multiplying a company’s share price by its number of shares outstanding, whereas book value or shareholder’s equity is simply the difference between a company’s assets and liabilities.
For healthy companies, equity value far exceeds book value as the market value of the company’s share appreciates over the years. It is always greater than or equal to zero, as both the share price and the number of shares outstanding can never be negative. Book value can be positive, negative, or zero.
Advantages of Equity valuation
1. Helps in Stock Analysis
There are many methods of equity valuation such as balance sheet methods, discounted cash flow methods and relative valuation methods.
Each method values an equity stock in a different way, for example, balance sheet valuation methods reflect how strong a company’s financial are, whereas discounted cash flow method reflects how strong is company’s earning potential. Both these method helps to analyze a stock from different perspectives.
2. Helps in Stock Selection
Equity valuation, by different methods to calculates a value of the stock which is considered as fair market value. The fair market value may be above or below the actual market value.
The stocks whose fair price is greater than actual market price is considered undervalued and a good investment.
Equity valuation helps find stocks that are undervalued and thereby helps investors in picking the right stocks to make an optimum portfolio.
3. Helps to identify Risk
Equity valuation especially when done through balance sheet method, helps identify the risk areas of the company. When factors are identified, investors and analysts can take precautions to avoid stocks with a red signal for the portfolio.
4. Aids Comparative Analysis
When relative valuation methods are used to determine the value of a stock, it becomes easy for the analyst to compare stocks within the sector and industry.