In the investing world, it's not uncommon to find terms with multiple meanings—and "equity" is one of those terms. Equity can mean a company's stock, the accounting value of a company, or the value that would be left if you sold your home and paid off your mortgage. But at its core, equity refers to ownership.
What is equity?
Equity is ownership, or more specifically, the value of an ownership stake after subtracting for any liabilities (meaning debts). For example, if your home (an asset) is worth $500,000 and you have an outstanding mortgage (a liability) of $400,000, you have $100,000 equity in your home.
In other words, equity is the theoretical cash you'd get in your pocket if you completely liquidated an asset today. That asset could be a car, a home, a business, or something else.
How does equity work?
The value of equity is based on the value of the underlying asset, so it fluctuates. The simplest way to think about equity in any asset is with a single question: "If I sold this asset today and paid off any related debts, how much cash would I have in my pocket?"
Let's look at that example of home equity again. Suppose you buy a home for $500,000, with a $100,000 down payment and a $400,000 mortgage. Your equity is the value of the asset (the $500,000 home) minus the value of any associated liabilities (the $400,000 mortgage). So when you first buy it, your equity in the home is $100,000, based on this formula:
Asset – liabilities = equity
$500,000 – $400,000 = $100,000
Now let's suppose that several years later, you've paid down part of the mortgage and now only have $300,000 outstanding. And further, let's suppose that your home has risen in value to $650,000 (nice going!). In that case, your equity in the home would have risen to $350,000, based on this formula:
$650,000 – $300,000 = $350,000
Your equity has increased as the value of your home has risen, but also as you've paid down the mortgage.
Of course, equity can also be negative. To see how, let's suppose that instead of a $100,000 down payment on that house you were only able to put $50,000 down, and that you took on a $450,000 mortgage. And let's imagine that shortly after buying the home for $500,000, home prices take an unfortunate dip, and the value of the home falls to $430,000. In that case, your equity would be negative $20,000, based on this formula:
$430,000 – $450,000 = –$20,000
To be sure, having negative equity is not ideal. But negative equity can also reverse itself. For example, if you kept paying your mortgage and waited it out, the home's value might recover and start to rise again.
Types of equity
As mentioned, equity comes in several forms, and the words "equity" or "equities" can be used in a few ways. Here are some of the ways you might encounter the term in the investing and financial worlds:
- Equities: This word can be used as a synonym for stocks, or for a specific company's stock. Remember that "equity" describes ownership, and stocks are essentially small positions of ownership in a company.
- Home equity: This is the value of your ownership stake in your home, as we described above. It's sort of like the amount of net worth you have in your home.
- Private equity: Private companies are ones that are owned privately. You can contrast them with public companies, meaning ones with stocks that anyone can buy and sell (i.e., companies that are owned by the public). Ownership in a private company is called "private equity." Some investing vehicles, called "private equity funds" specialize in investing in private companies.
- Shareholder equity (aka owners' equity): This is shareholders', or owners', residual interest in a company after subtracting for its liabilities. It's the value of all the company's assets, minus the value of all the company's liabilities.
While it can be confusing to see or hear the term used in so many ways, always remember that equity is fundamentally about ownership, and the value of ownership.
How to calculate equity
You can calculate equity using this straightforward formula:
Asset(s) – liability(ies) = equity
That formula is the same whether you're calculating equity in a home, a company, or something else. For example, say you own a car with a current market value of $10,000 but still have a $3,500 balance on your auto loan.
$10,000 – $3,500 = $6,500
Your equity in the car is $6,500.
While this formula can help put a dollar figure on your estimated equity, it's important to remember that if you actually sold your car, house, or company, the cash you walk away with from a real-world sale could be higher or lower than this theoretical figure.
How do investors use equity?
Investors can use the concept of equity to help them look for investing ideas, compare similar companies, and potentially even decide what stocks to invest in. For example, here are 2 important equity-related metrics investors may use:
- Book value per share: Book value is just a synonym for a company's shareholder equity. Book value per share takes the company's total shareholder equity and divides it by the number of shares outstanding to give a dollar estimate of the residual value that each share of the company is potentially entitled to.
- Price-to-book ratio: This ratio takes share price and divides by book value per share. If the ratio is more than 1, the company's shares trade for more than book value, and if the ratio is less than 1, the shares trade for less.
If a company trades for much more than its book value, then perhaps it's overvalued—or, perhaps it's growing very quickly, in which case its stock price may be more than justified. In and of themselves these numbers can't tell you whether you should invest in a stock. But they can help investors identify areas for further research.
Equity can also be an important concept to understand just in your own finances. If you take a job that includes equity compensation, then you'll be receiving shares as part of your total compensation package. This might give you an incentive to work harder (to help the company do well and hopefully help the stock to rise in value), and could give you an incentive to stick around at the company (since it may take time for your shares to vest). For many people, the chance to build home equity is a big part of the appeal of homeownership. And if you keep paying your mortgage and your home rises in value over time, that equity could end up becoming a big part of your net worth.