May 06, 2022
Formally called "book value" (because bookkeepers used to record this information), stockholders' equity refers to the value of a company's assets. Specifically, stockholders' equity is the difference between a company's assets and liabilities. The result isn't always the same for different companies, though – but let's start with some basic math:
Assets: Everything that a company owns has an objective value. This could include buildings, equipment, cash on hand, or even stock of other companies. Liabilities: The debts and obligations of a company, including accounts payable, accrued expenses, and short-term borrowings.
Here's an example: Let's say ABC Corporation has $10 million of assets and $5 million of liabilities on January 1st. At the end of January, it also has 40 shares outstanding, each having a $10 par value. Thus, the total value of the company's assets is $40 million, and its liabilities are $5 million. By subtracting the former from the latter, we get a book value of $35 million:
Book Value of Equity = Assets - Liabilities
In addition to the book value of equity, it's essential to recognize that companies also have a few other types of equity that we'll come back to later. However, for now, let's get back to calculating book value.
Market value is the current price at which markets are trading a particular stock.
Par value and market value can sometimes be difficult to compare because they don't always match up – especially when it comes to warrant companies. Warrants are different from traditional stocks because they aren't traded on the open market. Instead, they are traded like debt, so their par value equals the amount you invest in them. However, as long as the company's market value was greater than its par value at any point in time, then this accounting would still be acceptable.
One final note on stockholders' equity – most companies are required to have it on their financial statements. However, there are some exceptions – and if you're looking at the financial statements of someone else, then you may have to rely on their accounting for the book value of equity instead.
As the name implies, book value is simply the value of the assets and liabilities stated on a company's balance sheet. However, while this amount is often calculated relatively accurately (often even with a few months' worth of annual profitability), other "book" values can be calculated by taking other measurements into account. For example, analysts sometimes try to figure out their target market price for a stock if it were issued on its own. These so-called "market value multiples" can then be compared to the current price to determine whether they make sense.
The equity section of the balance sheet is the sum of three components: shareholder's equity, retained earnings, and earnings (which are presented as a single line item in the Net Balance Sheet).
Shareholders’ equity is sometimes called stockholders' equity or shareholders' capital. Shareholders' equity can be enhanced by receiving dividends from the company's net profit. This also increases stockholders' equity on a consolidated balance sheet.
Retained earnings are accumulated profits as stated in the company's income statement. They represent income received by a company that has not been distributed to its shareholders through dividends or share repurchases. Retained earnings are an essential indicator of a company's financial strength. They are often referred to as "Earnings Held For Re-investment."
Retained Earnings = Net Income - Dividends
Equity is reported on the balance sheet in two ways; either as a single amount or broken down into components. The three components are:
There are many ways to measure income, including sales revenue and net income. These measures depend upon an organization's ability to generate revenues from its primary activities, profitability, and anticipated growth.
Net Income = Revenue - Expenses
The financial analyst's view of profitability is a function of income, assets, and expenses.
The cost of capital is the rate required by investors to secure an asset or liability. There are two methods of calculating a company's cost of capital: the weighted average cost of capital (WACC) and the marginal cost of capital. The WACC is calculated by adding the costs of each class of capital and dividing that total by the total number of shares outstanding. On the other hand, the marginal cost method calculates the additional amount a company would have to pay to attract a different unit or dollar amount worth of investment funds. In both ways, common stock is one element of a company's overall capital structure.
The cost of financial capital is based on an expectation of return. The rate of return sought is referred to as the required rate of return. The average risk-adjusted rate of return that a company can expect is referred to as the company’s cost of equity capital. It is calculated by multiplying the company’s cost of debt by its debt beta (β) and then adding the company’s (cost of equity) risk premium to that product. This is called the Capital Asset Pricing Model (CAPM).
The cost of equity is calculated by estimating the market value of a company's common stock, its beta coefficient, and its risk premium. Market value is estimated by multiplying the current stock price or market value per share (P/E) by the number of shares outstanding. The beta coefficient measures the sensitivity that a company's stock has to movements in the marketplace; it reflects price changes based on market performance. The risk premium estimates the additional return expected from investing in a company over and above that yielded by investments with similar levels of risk.