'Equity’ is more than just Private Equity: A Quick Roundabout
In finance, equity simply means one’s share of ownership in a business. It can be measured and interpreted through two methods –
• Book value, and
• Market value.
While these are two usual methods to measure equity, the term often finds mention in a variety of contexts – shares, accounting and private equity industry.
Why diving into the usage of term ‘equity’ matters? Because when a business has to liquidate due to bankruptcy, the amount of money an investor receives (after paying to creditors) is determined by the equity held by one.
Three most prevalent references to equity are explained here. Let’s understand the differences.
Three sides of ‘Equity’
1. Equity aka ownership through stocks
When one buys shares in a company, an ownership stake is conferred on the person. An individual or even a private investment firm can buy stocks in a company through public exchanges or a broker. Say, you purchase 1000 shares of American Express. You can claim you own a small piece of the business. Often bought in numbers, shares in plural are referred to as stocks that entitle buyer with the ownership or equity in the business.
So, by first definition, when you mention equities in plural, it will most commonly be understood as the shares of stocks owned by you in a company – either through common stocks or preferred stocks.
When one mentions about ‘equity portfolio’, they are usually referring to stock holdings.
When stocks or other type of securities are purchased in a private company, it is referred as private equity (elaborated more on the industry in third section).
2. Equity in books
Equity when referred singularly, denotes equity in the books or in balance sheet accounting value. It’s the most common method used in accounting and even by private equity professionals. When shareholder’s equity is talked of, is calculated as the difference between assets and liabilities on the company’s balance sheet. It is determined by preparing financial statements.
Book Value of Equity = Assets – Liabilities
This is the balance sheet concept of equity. In accounting, equity of a shareholder is always listed in book format.
This figure can tell how much money would be left, if a business becomes insolvent. Value of equity in books becomes a function of: Share Capital; Contributed surplus; Retained earnings; Dividends; and Net Income.
Note, it is not same as net tangible assets since they exclude intangible assets such as goodwill which is included in shareholder’s equity.
For asset-heavy businesses, balance sheet equity is very important and useful. Take for instance, general motors. On the other hand, Oracle, wouldn’t find much utility in balance sheet equity or equity valued through books. The book method is also used by private equity firms, compounded by others.
3. Equity in private equity
In a special type of investment structure, equity refers much more than a share of ownership in publicly traded companies. When one talks of equity in a private holding, it usually means stake in a limited partnership. Private equity professionals invest limited partners money in companies. They buy private companies to sell to another buyer or exit through IPO in five to seven years of investment.
The value of equity in these investments is calculated through market value, instead of book value. In case of private companies, the market value of a business has to be estimated. One of the most common methods to estimate equity value in private companies is Discounted Cash Flow (DCF).
Unlike equity as on balance sheet or shareholder’s equity, private equity is not usually mentioned for an average individual investor. But high net worth individuals who are at least a million worth in value. Average investors can take aid of ETF (Exchange Traded Funds) to invest in private companies.