How Does Equity Work?

by Patrick Gleeson, Ph. D., ; Updated May 22, 2018
How Does Equity Work?

Equity is a financial term meaning "ownership interest." It is often used in the context of financial markets, where "equity" is a general term covering stocks, bonds and similar investment assets. It can also refer to your ownership interest in your house.

How Does Equity Work?

When equity refers to your stock market investments it means the total value of your investments minus any margin loans. For example, if you held stocks and bonds in your brokerage account with a value of $200,000 and you have a margin loan from your broker of $10,000, your equity in the account equals $190,000.

Similarly, if you have a house worth $350,000 and an outstanding mortgage balance of $150,000, your equity in your house equals $250,000. If you had also taken out an equity loan of $50,000, that would reduce your equity to $200,000. An equity loan is subordinated debt similar to a second mortgage on your house.

What is the Equity Ratio?

You calculate the equity ratio in your own investment account by dividing all margin debt by the total value of your investments. If, for instance, you have equities worth $200,000 in your account and margin debt of $30,000, your equity ratio equals $30,000 divided by $200,000, which is 15 percent.

You can make the same calculation for corporate debt, where to find the equity ratio you divide the company's total liabilities by stockholders' equity. There are several variations on corporate D/E (debt to equity ratio), but they're all related versions of the general idea: the degree of risk inherent in a corporation's percentage of debt.

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What is the Return on Equity Ratio?

Return on equity (ROE) expresses the ratio of corporate net income to shareholder equity. If, for instance, a corporation's annual income equals $120M and there are 30 million shares outstanding with a current price of $20, the ROE equals 120,000,000 divided by (30,000,000 times 20), or 120,000,000 divided by 600,000,000, which equals 20 percent. Generally, an ROE value of 20 percent is considered a very good return on investment.

Is a High Equity Ratio Good?

The higher an investor's return on investment, the better. Corporate returns over 15 percent are considered OK. Waste Management's first quarter 2018 ROE of over 32 percent is exceptional and the highest for that quarter among major corporations, far outpacing other companies in the same industrial sector, which had an average ROE of 12 percent.

But small corporations, and privately held companies especially, often do far better. Among privately held companies, for instance, medical organizations such as dentistry and physician groups had ROE's in 2017 of more than 90 percent!

There is, however, a related question to ask with respect to high ROE's, which is: is a particularly high ROE sustainable? If a company has a high ROE and relatively low long-term debt, absent some corporate missteps (let's never forget the Edsel!), there's reason to believe the company's high ROE is sustainable indefinitely. If there's a lot of long-term debt, however, payments on that debt will eventually lower the company's net profits and in that case, no, the ROE is probably not sustainable in the long run.

What Is the Total Equity?

Total equity is an accounting term that describes what's left after a company's liabilities are subtracted from its assets. In most corporate balance sheets, both assets and liabilities appear in separate groups: long term and current. The sum of current and long-term assets equals total assets and the sum of current and long-term liabilities equals total liabilities. Total assets minus total liabilities equals total equity.

How Is Equity Paid Out?

The answer to this question in relation to corporations is that often it isn't: it simply exists as an asset value. If shareholders' equity equals $1.2 billion, for instance, the value is inherent in the sum total of all investors' accounts. It really doesn't matter whether an individual investor or many thousands of shareholders retain the shares or sell them. If the latter, then, generally speaking, some other investor buys them and the total equity remains the same.

If the corporation issues a dividend, however, an equity payout exists in the amount of the dividend times the number of current shares. In theory, this means that with the distribution of the dividend, the share price will drop to fully reflect the payout. In practice, this isn't necessarily the case. If, as occasionally occurs, the investment community consensus is that the dividend is excessive in relation to corporate profits, perhaps to defang an appeal to shareholders by an activist investor, the loss in stock value may exceed the value of the dividend distribution. More often, when a company with an enviable balance sheet continues a long history of dividend distributions, the positive response of the stock market may reduce or even eliminate the mathematically calculated equity loss represented in the dividend payout.

About the Author

Patrick Gleeson received a doctorate in 18th century English literature at the University of Washington. He served as a professor of English at the University of Victoria and was head of freshman English at San Francisco State University. Gleeson is the director of technical publications for McClarie Group and manages an investment fund. He is a Registered Investment Advisor.

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