Buying a piece of a company is the cornerstone of investing. Find the answer to what is equity and the three primary methods investors have of buying equity in a corporation.
What Is Equity?
What is equity? Equity is viewed by the market as an ownership “share” in the revenue stream of a corporation’s income once all prior obligations and debts have been satisfied. The “share” price in an equity definition is the relative value given to the corporation’s earning potential based on a number of factors. These include general economic conditions, both in the industry and in the overall economy, earnings projection, projected corporate growth, corporate stage of development, and financial ratio analysis. When considering what is equity and its definition there are three major variants of equity to look at.
The Three Basic Types of Equity
Common Stock
Common stock represents an ownership in a corporation. Common stockholders participate in the earnings stream of the corporation through dividends paid and capital gains made on a per-share basis. Owners of common stock are responsible for the election of the Board of Directors, appointment of Senior Officers, the selection of an auditor for the corporate financial statements, dividend policy, and other matters of corporate governance. This may also be done on a proxy basis, whereby a third party may be granted the shareholder’s right to vote on their behalf.
The responsibilities associated with common stock mean the investor participates to a greater extent in the fortunes of the firm. Capital gains, through the increase in market price of the firm’s stock, accrue to a greater extent to the holder of common stock than to the holder of preferred stock.
Common stockholders also have a couple of significant rights should the business be wound down: limited liability to the creditors of the firm and a residual claim on any assets or income derived once all prior claims (mortgages, bondholders, creditors, etc.) have been satisfied.
Preferred Shares
Preferred shares are stock in a company that have a defined dividend, and a prior claim on income to the common stock holder.
Should the company wind up operations, preferred shareholders are paid any obligations owed to them. Should the Board of Directors suspend a dividend, for whatever reason, the preferred share usually has a cumulative clause in it mandating that any unpaid dividends must be paid fully before any dividends are declared and paid to holders of common stock. This means that the preferred share is a more secure investment, relatively speaking. The corporation issuing preferred shares may add differing features to the share in order to make it more attractive. These features are similar to those used in the fixed income market and include convertibility into common shares, call provisions, etc. Many have equated preferred shares with a form of fixed income security due to their defined dividend stream.
However, with the added security offered by the guaranteed dividend stream, the holder of preferred shares gives up the right to vote on issues related to corporate governance. Therefore, the preferred shareholder has little input into corporate policy.
Warrants
Warrants are a form of option usually added to a corporate bond issue or preferred stock in order to sweeten the deal. A warrant is a long-dated option that allows the owner to participate in the capital gains (losses) of a firm without buying the common stock. In effect, the holder of a warrant has a leveraged play on the corporate common stock.
As a form of option, a warrant has an exercise price and an expiry date. The exercise price is the price at which the holder may convert the warrant into common shares of the issuer. The expiry date is the last date on which the warrant may be converted into common shares. Given that a warrant is generally issued to reduce the cost of a debt issuer, the expiry date is usually more than two years from issuance. This allows warrants to trade separately from the bond with which they were issued, thereby providing the investor with a long-dated option on a firm’s common stock.
Drawbacks of Warrants as a form of Equity
There is a drawback to including warrants under the “what is equity” umbrella, particularly for those investors concerned with income. As an option, a warrant does not pay a dividend, and is subject to a certain amount of price compression as the underlying stock approaches or surpasses the exercise price. This is only a factor if the investor is purchasing the warrants when the common stock is trading near the exercise price.
Warrant holders have no voting rights until the warrants are converted into common shares. If the warrants provide for conversion into preferred shares, it is unlikely the holder will gain any influence into corporate governance upon conversion.
FAQs
Equity can be defined as the amount of money the owner of an asset would be paid after selling it and any debts associated with the asset were paid off. For example, if you own a home that's worth $200,000 and you have a mortgage of $50,000, the equity in the home would be worth $150,000.
What is equity short answer? ›
Equity is the amount of capital invested or owned by the owner of a company. The equity is evaluated by the difference between liabilities and assets recorded on the balance sheet of a company. The worthiness of equity is based on the present share price or a value regulated by the valuation professionals or investors.
What is an example of equity? ›
Equity is providing a taller ladder on one side or propping the tree up so it's at an angle where access is equal for both people. A line of people of different heights are watching an event from behind a fence. Equality is giving equal opportunity for each person to get a box to stand on to get a better view.
Is equity real money? ›
Equity is ownership, or more specifically, the value of an ownership stake after subtracting for any liabilities (meaning debts). For example, if your home (an asset) is worth $500,000 and you have an outstanding mortgage (a liability) of $400,000, you have $100,000 equity in your home.
Is equity your own money? ›
Your equity is the share of your home that you own versus what you owe on your mortgage. For example, if your home is worth $300,000 and you have a mortgage balance of $150,000, then you have equity of $150,000, or 50 percent.
Is equity good or bad? ›
Equity is important because it represents the value of an investor's stake in a company, represented by the proportion of its shares. Owning stock in a company gives shareholders the potential for capital gains and dividends.
How does equity work? ›
Equity is the difference between what you owe on your mortgage and what your home is currently worth. If you owe $150,000 on your mortgage loan and your home is worth $200,000, you have $50,000 of equity in your home.
What is the best way to define equity? ›
The word equity is defined as “the quality of being fair or impartial; fairness; impartiality” or “something that is fair and just.”
What is the difference between debt and equity? ›
Debt Capital is the borrowing of funds from individuals and organisations for a fixed tenure. Equity capital is the funds raised by the company in exchange for ownership rights for the investors. Debt Capital is a liability for the company that they have to pay back within a fixed tenure.
What is equity in real life? ›
If “fairness” is the goal, through these two methods of equity and equality, we can achieve it. Equity, means everyone is provided with resources specific to their needs to be successful.
The equity meaning in accounting refers to a company's book value, which is the difference between liabilities and assets on the balance sheet. This is also called the owner's equity, as it's the value that an owner of a business has left over after liabilities are deducted.
What is an example of equity in your life? ›
Another example is when a person with a disability is included in a workgroup with all the necessary accommodations to perform tasks just like other team members. These are just a few ways equity manifests in society, but there are many ways to promote it every day.
Can I cash out equity? ›
Many loan types require that you leave some equity in the home. To qualify for a cash-out refinance, Federal Housing Administration (FHA) and conventional loans require that you leave 20% equity in your home. VA loans are an exception, as they allow you to get a cash-out loan for 100% of the value of the home.
Is it better to have equity or cash? ›
Equity may have a bigger payoff one day — but in the short term it's more risky. What are your priorities when it comes to how you're going to use your compensation? Equity can't pay your mortgage, but cash can!
Can I cash my equity? ›
Releasing equity allows you to access the money you have invested into your home. Rules for equity release will depend on your lender, but usually you'll need to be over 55. To qualify for equity release: Age - There will be a minimum and maximum age that you will need to meet.
How do you explain equity to a child? ›
Equity refers to the principle of fairness. Equity is similar to equality, but equality only works when everyone starts at the same place. Therefore, equity focuses on helping people obtain what they need so they can get to a place where equality is possible.
What is the easiest way to understand equity? ›
It represents the owner's interest in the asset, and is calculated in both personal and business finance to gauge the health of an investment. Written as an equation, Equity = Assets - Liabilities. In personal finance, equity is money — your money — inside another asset like a car, a home or a business.
What does equity mean in kid words? ›
What is equity? Equity is often used interchangeably with equality, but they have distinctly different meanings. While equality demands everyone should be treated the same regardless of differences, equity is giving everyone what they need to succeed.
