What is Equity? How It Works, How to Calculate It, Types

A company’s total worth or the amount that a company has put into it is often referred to as equity. However, the actual valuation of equity can be done with the help of its market value and book value. A book value of equity is mentioned in the balance sheet of a company, while on the other hand, the market value of equity is the actual value of outstanding shares of a company. However financial analysts use both the market value and a book value of equity to determine its potential. 

What is Equity?

Equity can be referred to as the total assets of a company or a stakeholder after all debts are paid off. Equity, on the other hand, is the ownership of assets that may be subject to debts or other liabilities in finance. A company’s balance sheet shows equity as the difference between assets and liabilities in accounting. An equity’s balance sheet or share prices can be used to estimate its actual value.

How does Equity Work?

Equity, as its name suggests, refers to the fact that each shareholder receives the same rights and privileges in exchange for a share of the business. Shares, which resemble ownership, are held by nearly every business, whether public or private. In the stock market, companies can sell these shares to individual investors for cash. The money from the sale of these shares can then be used for other things, like growing the business, hiring more people, or investing in other businesses. Once the shares are allotted to an investor, then they can buy and sell them on the stock market to make a profit.

Types of Equity

The types of equity are mentioned below;

• Common Stock: A common stock shows the total capital investment of the owner contributed by its various shareholders. The value of common stocks is equal to the value of 1 stock multiplied by the total number of outstanding shares in the market. 
• Contributed Surplus: It refers to the additional amount paid by the shareholder over the par value of a stock. For example, if a company issues 1000 shares $5 par value for $ 10 per share. So, the value of common stocks will be 1000 x $5 = $5,000, however, the total amount earned by the company will be 1000 x $10 = $10,000, thus the contributed surplus will be $10,000-$5,000= $5,000.
• Preferred Stock: The preferred stock is very similar to the common stocks but the only difference is that it does not provide shareholders with a right to vote.
• Retained Earnings: The amount that is not being paid by the company as a dividend to its shareholder is known as its retained earnings. 
• Additional Paid-in Capital: The contributed surplus is also often referred to as additional paid-in capital, there is no notable difference between them.
• Other Comprehensive Income: Other comprehensive income includes income that has not been realized by the company yet and is not shown on the income statement of the company. For example payment from a customer that has 45 days payment credit.
• Treasury Stock: Treasury stock or often referred to as contra-equity is stock that is bought back by the company from its shareholders.

How an Equity’s Market Value is Calculated?

The market value of equity can be calculated with the help of a simple formula.

Market Value of equity = Number of outstanding shares X the current price of 1 share

For example, if a company “X” is trading at $500/share and has 10,000 outstanding shares, then the market value of equity will be $500 X 10,000 = $5,00,0000 ($5 million).

How an Equity’s Book Value is Calculated?

The book value of equity is the left amount that an individual shareholder of a company receives if the company is liquidated. It can be calculated with the help of the below formula.

Book Value of equity = Total assets –  Total liabilities

For example, if a company “Y” has a total asset balance worth $ 5,000,000 with total liabilities of $ 2,000,000. Then the book value of equity will be $5,000,000 – $2,000,000 = $ 3,000,000 ($3 million).

What is the Market Value of Equity?

The market value of equity also known as market capitalization is the total value of a company’s equity, which is calculated by multiplying the current value of a stock with outstanding shares of the company. This is the main reason behind the change in the market value of a company’s equity as it keeps on changing with the change in the total number of outstanding shares and its value. 

Book Value vs Market Value

Book Value	Market Value
It’s the actual worth of a company after paying off all liabilities.	It’s the value of a share trading multiplied by the number of outstanding shares.
It shows the actual worth of equity.	It shows an estimated worth of equity.
It’s shown on a balance sheet of a company.	It can be predicted with the price of stocks trading on the stock exchange.
It changes annually.	It changes frequently i.e. within moments.
It’s readily available.	It’s not readily available as it varies with the price of stocks.

Market Value Vs Book Value, which is more Important?

There are many key differences between market value and book value but the major difference is that market value looks forward to the future cost of equity while on the other hand book value takes into consideration all past and present records of a company. It appears on the balance sheet of the company. However, both the market and the book value of equity are equally important for example from a financial analyst’s point of view book value is more important, while on the other hand from an individual investor’s point of view market of equity is more important. 

Why is the Market value of Equity Important?

The market value of equity provides some valuable insights into a company, which is necessary for its shareholder to know. The market value of equity helps investors determine a company’s size, performance, and potential. The high market value of equity also sometimes increases the demand for stocks in the stock exchange as investors usually prefer to invest in companies with a high market value of equity.

Why is the Book Value of Equity Important?

The book value of equity is quite important as it shows a company’s actual financial condition and any specific time. A book value is also quite important from an investor’s point of view as it’s the actual worth of a company after all its assets is been sold and all debts are being paid off. 

Conclusion

Before investing in equity it’s quite important to look at its market value and book value. The market value and book value have equal importance but as an investor, it’s quite important to analyze both book value and the market value of equity. So that an investor can get an idea about the company’s past and present performance and its potential to make a profit for an investor. Investments in equity can be risky but can generate high profits in the short term, only if you have proper knowledge of equity investments. As an investor, it’s better to study a company’s income statement before investing in it. 

FAQs on Equity and Market & Book Value

Q1. What does it mean if the Market Value is less than the Book Value?

Ans. If the market value of equity is less than its book value, then the investors don’t believe that a company’s book value is actually worth it. 

Q2. What happens when Book Value Increases?

Ans. The price of a stock is believed to be undervalued if its book value is higher than its market value.

Q3. What is Adjusted Book Value?

Ans. When the actual book value of equity is adjusted to reflect its fair market value is called adjusted book value.

Q4. Can a Book Value be Negative?

Ans. Yes, if the actual value of the liabilities of the company exceeds the value of its total assets, then the book value is negative.