What Is Residual Equity?

Owners' equity is one of the things you find on a balance sheet. It shows up in what's called the accounting equation: company assets is equal to company liabilities plus owners' equity. Another way to look at it is that when you subtract all the liabilities from the assets, what's left is what the owners' stake is really worth. Residual equity is one way to further analyze the equation.

Economists have theories, and quite a few of them are about equity. Residual equity theory is based on the idea that if you're a common stockholder, you take a bigger risk investing in the company than anyone else. If the company goes belly-up, creditors and preferred shareholders get paid ahead of you. Residual equity is the equity that remains after you subtract liabilities, including bond debt, and preferred stockholders' equity from the total owners equity.

Residual equity isn't the only theory around. Proprietary theory clumps preferred and common stockholders together as owners, and looks at the firm as an extension of all the owners. If the firm makes money, the investors make money; losses to the firm hurt investors too. Entity theory, by contrast, says that even though the investors own the firm, the company is a separate entity with its own interests and finances, and not just an extension of the owners' interests.

The different theories represent different ideas about who's most important in a company. Proprietary theory implies that the most important consideration is the investors; entity theory says they're important, but the company has equal standing. The point of residual-equity theory is that if you're a common stockholder, you're more likely to lose your money than other investors. Therefore, it's only fair that the company make an extra effort to watch out for your interests.

If you think a company is a risky investment, figuring the residual equity can give you an idea how much common stockholders might get paid -- if anything -- in a worst-case scenario. It doesn't tell you the actual fair market value of the company, because the accounting rules for assets don't always consider that. To figure out the residual equity, take total equity from the balance sheet and subtract the total worth of the preferred shares. If you divide the result by the total number of common shares, you get the book value of a single share.