What is Owner’s Equity?
When you buy stock in a company, you’re buying an equity stake. But what does owner’s equity represent? In terms of stock ownership, equity represents the amount of money owed to a company’s shareholders after asset liquidation and debt payoffs. It’s your ownership of a portion of the total worth and value of the company. The fundamental nature of equity is part ownership of the company’s assets.
Shareholder equity is a term specific to stock in publicly traded companies. When referring to privately held companies, the term is owner’s equity. In either case, the meaning is the same: rights to the assets of a business. If you’re planning on becoming a shareholder or investing in private equity, it’s important to know what you’re entitled to when it comes to your stake.
How to Calculate Owner’s Equity
Whether you’re investing in a public company’s stock or part of a private company, the equation is the same simple one:
Owner’s Equity = Total Assets – Total Liabilities
To discern equity, companies and shareholders need to look at the balance sheet. The balance sheet provides a clear breakdown of the company’s assets and liabilities, which allows for calculation of owner’s equity.
- Identify total assets on the balance sheet
- Identify total liabilities on the balance sheet
- Subtract total liabilities from total assets to get shareholder equity
Of course, this assumes a couple of things. First, that the company’s balance sheet is accurate and second, that the valuations of assets and liabilities are accurate. If they are, it’s simple subtraction.
What’s Included in Owner’s Equity?
The most important concept is understanding what it represents. What are you entitled to? To find out, you’ll need to, again, look at the balance sheet. There are several core components that make up owner’s equity:
- Retained earnings. The amount of net income not paid out to shareholders.
- Outstanding stock. The standard issue of equity, bought and sold by investors.
- Treasury stock. Stock repurchased from investors in an attempt to raise equity values.
- Additional paid-in capital. Additional contributions to the business from investors.
It’s also important to consider what these capital sources fund and contribute to on the company’s balance sheet. For example, property, equipment and inventory are all assets. In the event the company liquidates and distributes wealth to shareholders and owners, these assets all offset liabilities. The resulting value, in cash, is what constitutes owner’s equity—based on the ownership stake of each person.
Example of Owner’s Equity
One of the best ways to illustrate it in action is through example. Here’s what it would look like in a private equity situation.
Stephanie gives Holly startup capital of $50,000 to buy a building ($100,000) and open a storefront café, in exchange for a 50% equity stake in the company. Over the next year business booms, so the café takes out a $20,000 business loan to buy new espresso machines and buys the building next to it to expand, which costs $100,000.
In the current year of this example, the café would have assets of $200,000 (property) and liabilities of $20,000 (loan). Assets minus liabilities would come out to $180,000 in owner’s equity, which would put Stephanie’s 50% ownership claim at $90,000. This is Stephanie’s share of total owner’s equity.
Is Owner’s Equity an Asset?
It’s easy to confuse the concept of owner’s equity and assets—after all, they’re closely intwined. The biggest difference between the two is that owner’s equity is an asset of the business owner, while at the same time actually being closer to a liability for the company. If the business were to fail, it would ultimately be responsible for repaying ownership claims against the business. Owners have a claim (asset) and the business has an obligation to pay against that claim (liability).
How Owner’s Equity Appears on a Balance Sheet
Owner’s equity appears on the balance sheet at the end of an accounting period. It’s shown as a net amount in the asset column. This is because, while shareholders may increase or decrease their ownership stake in a company, that stake still represents value for the company. In addition, businesses also show it in a capital account that shows net equity from all shareholders and owners.
Owner’s Equity Isn’t Business Valuation
While shareholder’s equity represents the amount owed to a company’s shareholders in the event of complete liquidation, it’s not an accurate representation of the business’ value. Business valuation takes many more (often intangible) factors into consideration. For example, some of the contributing factors to business valuation that operate independent of assets include:
- The value of the company’s cash flows and revenue streams
- The fair market value of the company in the eyes of buyers
- Intellectual property rights and claims, such as royalties
Owner’s equity is more in-line with book value, which is the net difference between the company’s assets and liabilities. Despite virtually the same equation, book value and owner’s equity aren’t the same. Book value calculation differs by multiplying a company’s share price by the number of outstanding shares.
Investors Need to Understand Owner’s Equity
When you make an equity investment, it means assuming some level of ownership over whatever you’re investing in. For private investments, it could mean a significant stake in the growth and success of a company. For public investments, it might mean joining millions of other shareholders. To discover the latest trends and investment opportunities, sign up for the Profit Trends e-letter below.
What matters is what you’re buying into. Owner’s and shareholder’s equity entitles you to part ownership of the company’s assets. As the company grows, so will the value of that claim.