What is Equity?

Most of us know Equity as the net value we have in our home, or the difference between the fair market value and the mortgage loan. Or the difference between the value of your car and the carrying value of your auto loan. These are all great examples of Equity.

Taking that simple definition, how do companies value their Equity?

We will describe Equity from the perspective of Generally Acceptable Accounting Principles (GAAP), which are a set of standards and rules required to be used by companies that sell shares publicly. Accounting Standards Codification (ASC) is FASB’s library of authoritative GAAP. Its like the Tax code, except its for accounting.

However, Equity as a standalone definition is the same across the board for the most part.

Equity – “represents the residual interest in the assets of an entity that remains after deducting its liabilities”

Let’s create a hypothetical scenario to carry us through the complex nature of how companies account for their Equity, it will be easier to understand under a simple business model. We will apply these complex financial accounting concepts to our imaginary business that way you understand exactly how public companies with more complex transactions, other events and circumstances carry their Equity on their books. Imagine you and a couple friends start a company and its main operation is a car dealership buying and selling classic cars. You decide that each one of you will invest $100,000 in cash, for a total of $300,000. Once everyone’s contribution is received, the Balance Sheet will look something like this:

Assets: $300,000

Liabilities: None

Stockholders’ Equity: 300,000

A companies Balance Sheet has a section at the bottom called Stockholders’ Equity. The most basic concept in accounting is that Assets = Liabilities + Equity, or differently put, Assets – Liabilities = Equity. If the accounting is done right, this equation is ALWAYS in balance. At a birds eye view, this section is as simple as the classic car dealership example where our assets (the cash) is greater than our liability (None) and the net difference is our Equity ($300,000), however, when we get closer and dissect the Stockholders’ Equity section item by item, it can get much more complicated. The word “stockholders” is describing the owners of this Equity, a stock is simply a piece of paper entitling individuals and entities to the ownership of the Equity. For example, you are the stockholder of your home, a single individual, and your mortgage company has a lien on this “stock”. While you are a single individual stockholder in your home, companies may have thousands or even millions of owners, each owning a different amount of shares in the stock. There are indirect owners as well, for example, mutual funds buy shares of stock on behalf of you, therefore, you indirectly own those shares through the mutual fund. Therefore, the Stockholders’ Equity of a company has all kinds of different owners: individuals, other companies, funds, and even the U.S. government. In our case, its just you and your buddies that own this section. Later, we will get into how this can change in different ways through additional share issuances.

What is an Equity Security?

Have you ever heard of the term Equity Securities? A security is simply a registered financial instrument. When companies first begin operations, there are a few owners in the Stockholders’ Equity section of the Balance Sheet, the founders. They all came together and put some money up in exchange for stock certificates, the piece of paper entitling them to the ownership of the company. At that moment, the value of that piece of paper is equal to the amount of cash each owner put up. However, as we will get into later, the value of this piece of paper goes up and down in many different ways.

Perhaps they even brought in some more owners as their business grew, but at some point, the business becomes successful enough to be able to afford the costs of selling their shares on an open market where anybody can buy a piece of the Stockholders’ Equity. Before a company can legally sell its shares (Equity) on the open market, it must go through a registration process with the SEC (Securities and Exchange Commission). There are certain documents that the company must file with the SEC, including a document called S-1 filing, which is essentially a share issuance filing.

The SEC is there to protect the investor. Back in the day, this wasn’t the case. There was mayhem on the streets. Laws were loose or there was no laws around the issuance of shares of a company. Nowadays, it is an extremely strict process, and a very costly one too. When a company decides to issue its Stockholders’ Equity onto an open market, the SEC has many different requirements. The requirements around accounting once a company registers as public is very costly. For example, the company must be audited with a PCAOB registered auditing firm to determine if the financial statements that the company produces are in accordance with GAAP and are free from material misstatements or omissions, a quarterly reviewed 10-Q must be filed and an annual audited 10-K, along with 8-K’s for certain events in between the other filings. Then there is additional share issuances a company can do which requires additional S-1 or S-3 filings. All of this for what? Well, the value of the shares have the potential for much greater growth in an open market leading to greater capital and more expansion, and so on. Those investors we talked about earlier, you and your buddies who have the earliest issued shares, those investor stand to make the greatest returns because the value of their shares have skyrocketed. We will get into how this all looks a little further down.

Back to Stockholders’ Equity, what does this little section of the Balance Sheet actually include? The Stockholders’ Equity section of the Balance Sheet has certain items within it to distinguish between the different ways that the Stockholders’ Equity section can be affected by transactions, events and other circumstances of a company.

Contributed Capital and Earned Capital

We can start by dividing the Stockholders’ Equity section into two broad categories: Contributed Capital and Earned Capital.

What do these mean?

Contributed Capital

Contributed capital is capital that is contributed by stockholders, or owners. It is often times called paid-in capital. Owners can contribute cash and even property, investments, and other financial instruments in exchange for ownership of the company. Just like you and your buddies invested cash in exchange for ownership, that is an example of Contributed Capital.

When you and your buddies started operations, you went down to the Secretary of States office and incorporated your business. During that time, you authorized a certain amount of shares, as described above, authorized shares are the maximum number of shares a company can issue. Its a figure established in your Articles of Incorporation during the incorporation process and changing it later requires amending the Articles of Incorporation. It is sort of arbitrary and the founders can authorize whatever amount they want to, however, it can depend on many factors as some states tax corporations on authorized shares for franchise taxes.

• Authorized Shares – this is the amount of shares that were authorized during incorporation and are listed in the articles of incorporation filing with the Secretary of State. This amount can be changed with a vote of the board of directors if needed.
• Issued Shares – of the authorized shares, these are the shares that have been sold to investors (including treasury shares)
• Outstanding shares – shares that are currently outstanding and owned by investors less any treasury shares repurchased by the company
• Treasury shares – shares that were once outstanding and were repurchased by the company itself. The company cannot buy itself, so if a company does a share buyback, those shares go into an Equity account called Treasury stock.

Common Stock and Preferred Stock

There are typically two classes of contributed capital: common stock and preferred stock. Common stock is the first line item in the Stockholders’ Equity section of the Balance Sheet and all corporations issue some form of common stock, which normally has a par or stated value that is assigned by the board of directors. This par value is mostly arbitrary and simply represents a legally binding agreement that the company will not sell shares below a certain price, such as $0.01. It’s a formality to meet certain states’ legal requirements for securities. The actual value of common stock has nothing to do with par value. Par value is important however for accounting, because when a company issues shares, the par value of those shares goes into the common stock account, while the excess fair value payment over par goes into an account called Additional Paid-In Capital, which we will talk about in a second.

Preferred Stock is a separate class of stock. Unlike common stock, preferred stockholders get paid dividends before the common shareholders do and have preferential treatment, hence the name. Preferred shares do not have voting rights like common shareholders do. Also, when a company is liquidating, preferred shareholders have first dibs, after lenders, on the liquidation proceeds. However, the share value of preferred shares are typically more stable and not as volatile as common shares that may be traded on an open exchange. There are also cumulative preferred shares, participating preferred shares, redeemable preferred shares, and others that we will not get into today.

Continuing with our classic car dealership, the cash was exchanged for common stock. Let’s assume that the par value, or stated value, of the common stock was set at $1 per share and you decided to issue the shares to each one of you. Therefore, as the initial issuance of those authorized shares, each owner gets 100,000 shares issued at par in exchange for the $100,000 in cash. As shown above, our assets (cash) increased by $300,000 from the 3 founders and our common stock account in the Stockholders’ Equity section increased by $300,000. Therefore, each owner now carries a 33.3% ownership interest in the company.

Additional Paid-In Capital

This line item exists due to the difference between what the common stock or preferred stock sold for, or issued at, and the par or stated value. It refers to the money an investor pays above and beyond the par value price of a stock.

The easiest way of explaining Additional Paid-In Capital is with an example.

Let’s assume our classic car dealership has been doing really well in Year 1. We purchased and sold inventory at a profit, we purchased a building to work out of and some equipment for our garage. At the end of Year 1, an investor approached our classic car dealership and wanted to invest in the company. We decided to bring on a 4th owner and issue an additional 100,000 shares for $250,000. There is now 400,000 shares outstanding, the original 3 owners at 100,000 shares each sold at par value and the newly issued shares of 100,000 above and beyond par value. However, because we sold the additionally issued shares for more than par value, we must utilize the Additional Paid-In Capital account. Remember, each share had a par value of $1, the new investor paid $2.50 per share. That means $1.50 per share goes into Additional Paid-In Capital.

The Contributed Capital section of the Stockholders’ Equity looks something like this after the 4th owner:

Stockholders’ Equity:

Side note: Book Value Vs. Fair Value

Why would an investor pay more than the book value of a company? Remember, before we issued those new shares to the new owner, our book value of Stockholders’ Equity was $300,000, which included $300,000 of Contributed Capital from the original owners. Our new owner was buying 25% of the company, which equals a book value of $75,000, yet they paid $250,000 for the 25% ownership. That means they are paying $175,000 over the book value of Stockholders’ Equity. The fair market value of Stockholders’ Equity is often times very different than the its book value.

Firstly, in accrual GAAP accounting, certain items on the Balance Sheet are carried at historical cost as a measurement attribute, items such as property, plant, and equipment. You can have a building that was purchased 20 years ago and the value on the books is carried at historical cost less any accumulated depreciation. The fair value of that building may be 20 times of what it is carried on our books. Certain investments are carried at amortized cost, which ignores fair value changes in those investments.

Other items of value are not even recognized in the books, for example, imagine our classic car dealership has 1 million followers on our Instagram account. We all know that Instagram account has a fair market value, yet it is not recognized on the Balance Sheet as an asset. The reason why is because the costs incurred to build that Instagram account to 1 million followers were expensed in the period incurred as advertising and marketing costs and were not capitalized on the Balance Sheet as an asset. What if our CEO is one of the best CEO’s in the world? Does that carry value? If it does to an investor, that fact is not reflected in our books. What about the fact that we were profitable for the last however many years? Or that investors anticipate profits growing over the next 5 years? That anticipation isn’t recognized in book value. What if we have a list of customers that was internally generated over the years, 1000’s of customers who love classic cars, does that list carry any value on the open market? Of course it does, yet it is not recognized in our books, only the registration costs and legal fees are capitalized on these internally developed intangible assets. A competitor of ours would pay a ton of money for that list of customers.

You see, our book value of $300,000 from contributed capital does not align with the fair value of the Stockholders’ Equity. The new investor understands this fair value and book value difference and that certain items of value are not recognized in GAAP accounting due to the conservatism principle. The $250,000 that the new investor is offering in exchange for 25% ownership takes in account all of those unrecognized items of value that were mentioned above.

As we issue an additional 100,000 shares of common stock to the new investor, our Equity increases by the $250,000 investment. Our common stock account increases by the par value (which was $1 per share) for $100,000, our Additional Paid-In Capital account increases by the other $150,000. Recall that Additional Paid-In Capital is for investments in stock in excess of par value.

The original owners were diluted. The 3 original owners invested $100,000 each and owned 33.3% of the stock equally, our Outstanding Shares were at 300,000. Now that we have a new owner on board, we issued an additional 100,000 shares for a total of 400,000 shares Outstanding. Now, the 3 founders own 25% of the Stockholders’ Equity instead of the original 33.3%. They originally invested $100,000 each, but because of the new investment, they now own 25% which equates to a new book value of $137,500. They can now exit the company and sell their shares to somebody else at the $137,500 or more if some new investor is willing to pay more because they see other synergies that the first investor didn’t.

The Stockholders’ Equity section of the Balance Sheet doesn’t only grow from investors contributing cash in exchange for ownership interests (contributed capital). The Equity section also either increases or decreases from the results of operations of the company. The Net Income on the Income Statement, if positive, will add to the Stockholders’ Equity. The company utilizes its assets, like the cash that was exchanged for stock in contributed capital, to generate earnings through its normal business operations.

Let’s assume that during your first year of operations, the company generated $100,000 in Net Income. The last line item on the Income Statement is Net Income and during accounting period closing, we take this Net Income account and throw it into an account called Retained Earnings, which is a Balance Sheet account. The Income Statement is a period-of-time financial statement, for example, a typical accounting period could be monthly or annually. A Balance Sheet is a point-in-time financial statement, for example, the Balance Sheet would be put together on the last day of the accounting period.

The Earned Capital section includes Retained Earnings and Accumulated Other Comprehensive Income (AOCI)

Retained Earnings represents earnings accumulated since the company’s inception that have not been paid out to shareholders. The interior workings of Retained Earnings includes Net Income or Loss, less dividends paid out to shareholders, and any prior period adjustments to Retained Earnings for corrections of an accounting error that occurred in the financial statements in the prior period. When a company earns profits from its operations, this net income travels from the income statement to the Balance Sheet in the form of Retained Earnings. A company can then decide to distribute this income or keep it in Retained Earnings for further expansion.

Think of Retained Earnings as a piggy bank that your company uses to accumulate Net Income every period. A company may elect to declare and pay dividends to its shareholders, essentially breaking the piggy bank and redistributing it among the owners. The company doesn’t have to distribute all of it, it can be a very small portion of it, or none at all. Dividends don’t have to be in the form of cash, they could be stock dividends and even property dividends. Most investors are not investing their cash to get a dividend return, most investors want share appreciation.

Remember that our Stockholders’ Equity section currently has a total book value of $550,000. Our $100,000 Net Income from our classic car dealership this year can either be distributed as Dividends to the 4 owners, or it can remain with the company and be put into this piggy bank. If we decide to keep it in the company, our Stockholders’ Equity is now $650,000, of which $550,000 is in Contributed Capital and $100,000 is from Earned Capital.

The Stockholders’ Equity section now grew by $100,000 by Earned Capital that came from the Income Statement. If Equity goes up because the company earned it, that’s good news, but it important to now if its sustainable. If Equity goes up due to contributed capital going up, in other words, we issue additional shares in exchange for cash, that means the current stockholders are being diluted and the owners proportional share in the company is decreasing, that isn’t always a good thing.

Sustainability

Sustainable increases in Equity from Retained Earnings means that its from operating income, coming from the core business operations of the company, not from infrequent or unusual items. The Income Statement includes a non-operating section, this section houses infrequent or unusual items that are not components of the company’s primary operations but are related to secondary or auxiliary activities. For example, if our classic car dealership earns interest income on the cash we have in the bank, this interest income is considered a other income, not part of our core operations. Our dealership is not in the business of earning interest income, we are in business to earn gross profit on classic car sales.

For example, if we sold a building that was on our books that had a carrying value that was much less than its fair market value, the Income Statement would show a large non-operating gain. Therefore, our Retained Earnings will go up because Net Income is up, however, its not sustainable because it mostly came from that non-operating gain. We could of had a loss in our operating section of the income statement, and the non-operating section had the large gain from the building sale that was greater than that loss, our net income would still be positive and would increase our Retained Earnings, however, its not a sustainable increase.

Accumulated Other-Comprehensive Income (AOCI) is accumulated amount of changes in Equity other than those from transactions with owners (contributed capital) that are not reported in the Income Statement.

Other-Comprehensive Income is more of a complex topic, but in general, some transactions, other events and circumstances that affect a company are not appropriately put on the income statement. These transactions have the potential to distort net income, and user decisions, and therefore are not included in the income statement for a companies normal operations. One way this happens is when a company purchases a debt investment, like a bond, and that bonds fair value changes throughout the accounting period, this fair value change is recognized in OCI and not in Net Income.

Back to our classic car dealership, let’s assume we purchase a bond at par value as an investment for $50,000. This bond will be carried at amortized cost, which our cost is face value of $50,000. When this bond goes up in value to $60,000 at the end of the reporting period, this would be an unrealized holding gain. It’s unrealized because we haven’t sold it yet. This unrealized holding gain would be reflected in the OCI account as a direct increase to Equity. There are other transactions that flow directly to Equity through OCI such as foreign currency translation gains and losses, certain changes in post retirement benefit plans, and deferred gains and losses on derivatives. These transactions are more complex and not for this discussion.

Now that we have gone through Contributed Capital and Earned Capital, here is how our Stockholders’ Equity section looks so far.

Stockholders’ Equity:

Other Items of Stockholders’

Equity Treasury Shares

Treasury shares are shares that are repurchased by the company that were previously issued and outstanding. The treasury account is what’s called a contra equity account, contra meaning it goes against. It is always reported as a reduction in the stockholders’ equity section. When a company issues its authorized shares and adds to its Outstanding shares, it has the option to repurchase those shares back. If the company decides to repurchase these shares, perhaps to decrease the amount of floating shares on the open market, the shares will be added to the treasury pool. These shares can then be reissued back to the open market or can be retired.

Non-controlling Interest

The Non-controlling interest section of the Stockholders’ Equity is a more complex topic that includes business consolidations, which is part of advanced accounting. When a company purchases stock in another company and obtains a certain level of control, typically when the company reaches a percentage of ownership that 50% or above, the ability to control is presumed to be present. When control is present, the parent must consolidate the two financial statements during reporting. The parent’s controlling interest, or its investment in the investee, is carried in an investment account. The non-controlling interest in the Stockholders’ Equity section is the portion of the investee that is owned by outside interest, or the interest that is not owned by the parent. The parent consolidated 100% of the investee, even though they have less-than-wholly interest, such as 80%.

For example, as an over-simplification, let’s say our classic car dealership purchases a competitor across the street. We pay $1,000,000 in consideration for 80% ownership interest. Our $1,000,000 investment represents 80% of the fair value of the investee, while the other 20% will also be valued at fair value on our books, even though we don’t own it. During the end of the year, we will consolidate our two companies and combine 100% of the assets and liabilities.. Then, the “non-controlling interest” of 20% will be listed in our Stockholders’ Equity section to represent the ownership of the fair value of the investee.

Summary of Equity

At a birds eye view, the Stockholders’ Equity section of a company’s balance sheet is identical to that of the example of a home mortgage, where the value of the asset (the home) is more than the liability (the loan), and the difference is the Equity. However, as we have shown, once we dissect the Equity section, it can get a lot more complicated. An important part to remember about a company’s Stockholders’ Equity is the book value, or the accounting value, is many times very different than its fair value. The fair value of equity is what a willing buyer would pay on an open exchange.

The fair value of the Stockholders’ Equity is many times not based on objective truth. An investor takes into account many different variables when it comes to valuing a company. This value is generally inherent in the publicly traded share value, which has no correlation with the book value. When a company issues additional shares at this new share value, the company would then recognize some of this value appreciation. Like we mentioned earlier, imagine a company has a very successful CEO with many successful IPO’s under their belt while another company has an average CEO, would the company with the more successful CEO be valued higher? What about the fair values of property, plant, and equipment, which we mentioned earlier were valued at historical cost less accumulated depreciation? Or the fact that the company has been profitable for the last 5 years versus another company has been operating at a net loss for the last 5 years, wouldn’t the profitable company carry a higher fair value to an investor? What if the industry the company operates in is about to see a huge boom, wouldn’t that make the company more valuable to investors? All of these are not recognized on the Balance Sheet, and therefore are not recognized in its book value. When a company becomes successful enough to issue shares on a publicly traded stock exchange, the potential for share value appreciation is much greater than selling shares privately, as the share prices rise, a company may issue additional shares to take advantage of that increased share value.

Simply put, the Stockholders’ Equity is a combination of contributed capital and earned capital. Contributed capital is the capital raised in exchange for ownership interest and includes items such as Common Stock and Preferred Stock. Earned capital is the capital that is earned by the company’s day-to-day operations and includes items such as Retained Earnings and Accumulated Other-Comprehensive income (AOCI).