Equity (finance)

In the world of finance, equity represents an ownership interest in an asset or a business. It is not simply the total value of what a person or company possesses. Instead, equity is the specific portion of ownership that remains after all debts are accounted for. To find this value, one must subtract liabilities from the total value of assets. A liability is a debt or an obligation that must be paid. For example, if a car has a market value of $24,000 and the owner owes $10,000 on a loan, the equity is $14,000.

Equity can apply to a single item or to an entire corporation. When a person buys an asset like a house using a secured loan, they do not own it fully until the debt is gone. The lender holds a right to repossess the asset if the borrower defaults on payments. In these cases, equity is the market value of the asset minus the remaining loan balance. This figure may differ from the total amount of cash a buyer has paid toward a loan. This is because loan payments include interest expenses and do not account for changes in the asset's market value.

Sometimes, a situation arises where liabilities exceed the value of the asset. This creates a deficit, which is often called being "underwater" or "upside-down." The type of loan used determines how this deficit is handled. Many houses are financed with non-recourse loans. In this setup, the lender assumes the risk if an owner defaults while in a deficit. Other assets may use full-recourse loans. These make the borrower personally responsible for any deficit that exists.

The term "equity" has deep roots in English history. It developed during the Late Middle Ages to support growing commercial activities. During this time, England used a system of equity law to complement common law. Common law courts primarily handled questions regarding property titles. However, equity courts focused on contractual interests in property. This allowed one person to hold the legal title while another held the contractual interest. The courts ensured that the administration of these contracts was fair, or "equitable."

For businesses, equity is more complex due to complicated debt structures. A company might have some debts secured by specific assets and others guaranteed by the whole business. In financial accounting, the fundamental accounting equation must always balance. This rule states that total assets must equal the sum of total liabilities and total equity. Accountants track these figures on a document called a balance sheet. This statement shows total assets, specific equity balances, and total liabilities.

A balance sheet lists various types of equity depending on the business. Share capital and capital surplus reflect the original money provided by investors. Treasury stock is a "contra-equity" balance, meaning it reduces total equity when a company repurchases its own shares. Retained earnings represent the running total of a company's net income and losses. These earnings can change due to many events. Capital investments increase equity, while paying dividends to shareholders reduces retained earnings.

Investing in equity is a common way to build wealth. People purchase stock in companies expecting to receive dividends or capital gains. Equity holders often receive voting rights. These rights allow them to vote for a board of directors or influence management. If a company undergoes liquidation, owners have a residual claim on the remaining equity. However, if the equity is negative, the owners' claim is void, and creditors bear the loss. This protection is known as limited liability.

Valuing equity is a specialized task in the financial markets. A company's equity balance does not always dictate its stock price. Investors also consider business risks, access to credit, and market demand. Some experts use the theory of intrinsic value to find profitable investments. They look for stocks priced below the present value of future earnings. Famous advocates of this method include Benjamin Graham and Warren Buffett. Others use the "Merton model," which views stock-equity as a call option on the entire company's value.