Equity is the final major investment category, along with cash equivalents and fixed income.
Today we will review the concept of equity, in general, and in relation to companies.
Equity in General
Equity is anything that represents an ownership interest.
If you own a home (or possibly even a vehicle), you likely borrowed money from a bank (or similar) upon purchase. But you also contributed a portion of the cash yourself. This percentage is your equity interest in the house (or car). Over time, as you pay off the debt, your level of equity increases proportionately in the asset.
Your equity at any point in time equals the current market value of the asset less any outstanding debt and accumulated interest owing on the asset.
Equity and Margin Accounts
Some readers may have, now or in the future, brokerage accounts that allow margin trading.
A margin account allows investors to leverage by borrowing funds from the brokerage house using their investment portfolio as collateral. The amount that may be borrowed is dictated by the type of assets and market value of the investments within the account.
The equity portion is the value of the total investment portfolio minus the amount that has been borrowed.
While this may seem the same as a mortgage or a car loan, it is not. Asset values within a portfolio fluctuate daily. If prices fall, even in the very short term, you may be required to make additional contributions to the account (margin calls) to cover shortfalls. If you cannot, your assets will be sold to meet your minimum margin levels.
For most investors, margin accounts are a risky proposition. Take care if you ever decide to set up a margin account.
Debt is Not Equity
Creditors, like a bank that loans you money, are not equity holders in your home or vehicle.
Creditors may have a lien, or claim, to your overall assets (general) or specific assets (mortgage), but they do not have any right to participate in your affairs (unless incorporated into the the debt agreement or via court order).
The debt holder is simply entitled to the principal outstanding and all agreed upon interest payments.
Owning an equity interest gives the holder the right to participate in the company’s performance. As results may vary over time and circumstances, equity is riskier than debt.
The debt holder is only concerned about seeing the debt serviced in a timely manner. The equity holder wants to see an appreciation in the asset value or other performance factor that increases the value of the equity interest.
Corporate Equity
Within a company, equity refers to the funds contributed by all shareholders. While there may be a variety of share classes issued, the main form is common stock. And, as we saw previously, some companies issue preferred shares.
Equity includes more than just the capital contributed by shareholders. It also includes the company’s retained earnings.
Retained earnings are a company’s accumulated earnings over its life less dividends that have been paid to shareholders.
Combined, retained earnings plus contributed share capital, equal a company’s shareholder equity on its balance sheet.
Companies issue shares to raise capital. The proceeds are used to finance current operations, pay down pre-existing long term debt, or allow for expansion of the company.
Authorized Versus Outstanding Capital
Each class of stock has a maximum number of shares that may be issued. This maximum is known as the company’s “authorized capital” and is stated in the corporation’s “articles of incorporation”.
The number of shares actually issued to date is known as the “outstanding shares”. It is also referred to as the “float”.
For example, ABC has an authorized limit of 10 million, Class A common shares, according to its articles of incorporation. As at December 31, 2016, ABC has 1 million, Class A common shares outstanding.
The number of outstanding shares includes any “restricted stock” that may exist. Restricted shares are those that have restrictions on their ability to trade.
Perhaps corporate insiders (e.g. officers of the company) own shares that cannot be sold for a 5 year period from issue. Often this is used as an incentive for senior employees to stay tied to a company for long periods. Also, by having a vested interest in the long term growth of the shares, the employees personal objectives are in line with other shareholders.
Shares that have been repurchased by a company through open market transactions or “share buy-back programs” are not considered outstanding stock.
Note that if there are no repurchased shares in existence, or those that previously were purchased by the company have been retired, the outstanding shares may be referred to as “issued and outstanding”.
Knowing the number of shares outstanding is important when analyzing a company’s value. This may include “earnings per share” (EPS) or “market capitalization” calculations.
Knowing the number of shares authorized is also important. It allows you to assess the potential dilution effect on existing shareholders if new shares are issued.
Next we will take a deeper look at common shares.
