Financial metrics are a crucial part of assessing the health of an organization. The more metrics available—and the more in-depth they are—the better-equipped leadership is to assess the health of the organization.
Few financial metrics paint a clearer picture of financial health than shareholders’ equity. With this sole metric, investors get a quick snapshot of the profitability of an organization. However, there are more use cases for equity than just investment.
Learn why shareholders’ equity is such an integral indicator of organizational capability, how it differs from similar metrics like stockholders’ equity, and how to calculate this key metric for yourself.
What is shareholders’ equity and what does it tell you?
Shareholders’ equity is a synonym for an organization’s net worth. Shareholder equity is what the organization’s owners hold in its total value or book value.
Shareholders own the organization; their level of equity indicates the level of equity or ownership they have within the organization. Therefore, shareholder equity outlines the total dollar amount these owners are entitled to if the organization’s assets were liquidated and all debts were covered.
In simpler terms, it is the difference between the organization’s total assets (assets where shareholders have equity) and the organization’s total liabilities (the amount of debt the organization owes to external parties).
An organization has many different shareholders who are entitled to shareholder equity. How shareholders hold a stake within an organization depends on the manner of their investment. There are four different categories of shareholder equity that you might find on an organization’s shareholder equity balance sheet:
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Common shares
Common shares are a type of stock that indicate holders have a claim to an organization’s profits in the present and the future. Common shares come with a key benefit: holders vote to elect board members. However, compared to other types of shareholder equity, common shareholders are the last to receive payouts if the organization’s assets are liquidated.
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Preferred shares
Preferred shares are similar to ordinary shares, the difference being that preferred shareholders are conferred with a range of additional benefits. While preferred shareholders sometimes don’t have voting rights in board elections, they do earn higher yields and dividends than common shareholders. Additionally, preferred shareholders are paid out before common shareholders if the organization liquidates its assets.
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Paid-in capital
Paid-in capital refers to the total cash amount common and preferred shareholders have paid into the organization, representing the amount of capital generated through the sale of equity. It is a comprehensive line item that is found in an organization’s balance sheet beneath shareholder equity. Additional paid-in capital is often stipulated on the balance sheet, indicating the amount of capital paid above the par value by shareholders.
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Retained earnings
Retained earnings represent the total amount of profit that remains after an organization pays off direct and indirect costs, taxes, and dividends to shareholders. In effect, retained earnings are profit held by shareholder equity.
Components of shareholders’ equity
The constituent elements of shareholders’ equity are found in financial documents, like an organization’s earnings report. An earnings report is a general outline of an organization’s financial performance: the revenue they’ve brought in, their outstanding debts, etc. Shareholders’ equity is part of these kinds of financial documents because shareholders’ equity is a key performance indicator (KPI).
So, what are the components of shareholders’ equity? Four of the primary components of shareholders’ equity are the types of equity mentioned above: common stock, preferred stock, paid-in capital, and retained earnings.
Additionally, there are treasury shares. These shares are stocks that the organization once sold on the public market that shareholders repurchase for the organization. Treasury shares, or treasury stocks, are also known as stock buybacks, wherein shareholders increase their ownership by retaining a greater number of shares for the organization and increasing their earnings per share (EPS).
Finally, unrealized gains and losses are also components of shareholders’ equity. This metric refers to holdings that have been bought or sold but haven’t been realized yet, i.e., the transaction has yet to be finalized. They primarily exist on paper, though because they are transactions in action, they must factor into shareholders’ equity.
How is equity used in compensation packages?
There are several ways to incentivize stakeholders in a corporate setting. Beyond transparent salary and benefits, many organizations offer employees compensation packages that include opportunities to gain equity in the organization.
Equity opportunities are a great long-term asset for employees. After all, what better way to make them part of the organization than by giving them a real stake in its success? Employees are likely to take a long-term view of their relationship with the organization if they have an equity arrangement in their contract.
Plus, equity isn’t just a great opportunity for employees.
Employers stand to benefit from equity-oriented compensation packages as well. For one, equity is a great motivator for employee performance; they’ll work harder and longer if they have a stake in the organization. Additionally, equity packages are cost-effective for employers. A lucrative equity package keeps value within the organization instead of distributing resources through salaries and employee benefits.
Equity takes many forms in a compensation package. Here are a few to consider:
- Stock options: Stock options give employees the right to buy organization stocks at an agreed-upon period at a designated price.
- Restricted stocks: Restricted stocks are employment stock options with conditions: they are non-transferable, and there is a designation on future sales.
- Non-qualified stock options: Non-qualified shares of stock allow employees to acquire organization stock at a preset grant price. However, employees must pay income tax on their holdings after they sell.
- Performance shares: Performance shares are stock options triggered when employees meet certain performance benchmarks. In other words, when employees do well, they receive bonus payments in stocks.
What does positive vs. negative shareholders’ equity mean?
Shareholders’ equityis a quantifiable metric that assesses the financial health of a given organization. So, what does good or bad shareholders’ equity look like?
Considering that shareholders’ equity is a function of an organization’s held assets and its outstanding liabilities, positive SEs are a good sign. Positive SE indicates that shareholders have more ownership of the organization’s assets. Higher rates of ownership over held assets are a strong indication of the organization’s stability; the organization is not at risk of default because equity outweighs any outstanding debt.
Alternatively, negative shareholder equity indicates that an organization’s liabilities (e.g., associated debts, loans, etc.) exceed the total equity held by the organization owners. Financial experts deem this negative balance as a high-risk situation.
An organization’s value is held in debt. In the event those debts are called upon, liquidation of the organization and its current assets render it solvent, which has devastating effects on the organization’s shareholders.
How to calculate shareholders’ equity: Formula and balance
SE is known as a balance sheet equation, meaning that all the necessary information to calculate this metric is on standard financial statements like balance sheets. Broadly, shareholders’ equity is determined by the difference between the total of an organization’s held assets and its liabilities.
In this context, the organization’s held assets might include everything from long-term fixed assets like machinery and property to short-term marketable securities and prepayments, total outstanding liabilities, both current liabilities and long-term liabilities, refer to loans or accrued debt within the organization.
Here’s an easy formula:
SE = Total Assets – Total Liabilities
Using this version of a shareholder equity formula, an organization with 3 million in total held assets and 1.5 million in liabilities has a shareholders equity of 1.5 million dollars.
Another formula finds SE by adding share capital and retained earnings, then subtracting outstanding shares of treasury stock:
SE = (Share Capital + Retained Earnings) – Treasury Stock
Shareholders’ equity is always in a state of dynamic flux. Additional reports the organization makes throughout the year provide yet more information to calibrate shareholders’ equity over time.
For instance, if someone wants to determine shareholders’ equity from an existing calculation, they first need to make any additions or subtractions of equity infusion made throughout the accounting period. That might include cash flow infusions from purchased shares or reductions from stock buybacks reclaimed as the organization’s shares.
Additionally, ongoing accounting equations must factor in the organization’s net comprehensive income, deductions from paid-out dividends, and losses sustained over the period. By including these additional factors in the initial assets less liabilities calculation, one arrives at an accurate representation of shareholders.
Shareholders’ equity examples
Enough with the intangibles. For a real-world example, let’s look at Tesla’s shareholders’ equity.
As of March 2023, Tesla’s total held assets are 86.83 billion dollars; its total held liabilities are 37.59 billion dollars. Using this data, we’ve determined that Tesla’s shareholder value is 49.24 billion dollars.
Organizations with robust levels of shareholder equity are sometimes more inclined to include equity in their compensation packages. Several up-and-coming business entities have used equity-based compensation offerings to incentivize their workforce. Here are a few industry leaders who have embraced competitive equity in their compensation packages:
Snap
Stock-based compensation ratio: 46 percent
Stock-based compensation ratio: 41 percent
Lyft
Stock-based compensation ratio: 40 percent
Instacart
Stock-based compensation ratio: 39 percent
Airbnb
Stocked-based compensation ratio: 36 percent
Final thoughts
Shareholders’ equity is a multi-faceted metric that serves many purposes. For one, it helps investors determine an organization’s investment value. When investors see how much stake shareholders have in the organization, they have a better sense that the organization is in strong, reliable hands.
But equity serves more purposes than just investment metrics. Organizations that leverage their equity in compensation packages stand to boost their performance and increase employee retention, among other benefits. Knowledge about shareholder equity serves stakeholders within the organization and outside of it.
FAQs about shareholders’ equity
Do you still have lingering questions about shareholder equity? Here are a few answers to frequently asked questions about shareholders’ equity to help you achieve a complete understanding of the subject.
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Is shareholders’ equity an asset?
Shareholders’ equity is not an asset. While calculations of shareholders’ equity might include ownership’s held assets, SE itself is not an asset as such. On the contrary, SE refers to the financial obligation an organization has to its shareholders.
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What is the difference between shareholders’ equity and stockholders’ equity?
Shareholders’ equity and stockholders’ equity are synonymous terms. The terms shareholders’ equity, stockholders’ equity, and owners’ equity might be used interchangeably in a financial context.
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What is the relationship between shareholders’ equity and assets?
Shareholders’ equity is a function of an organization’s assets and liabilities. For that reason, shareholders’ equity and the organization’s assets are closely related. The more assets held by the organization over its liabilities, the stronger the shareholders’ equity; the inverse follows that fewer held assets about liabilities equate to lower shareholders’ equity.
