What Is Equity? Meaning, Advantage, Impact

Introduction

Equity markets, equity investment, equity stake…you may have encountered such terms while exploring the stock markets. But do you understand the true meaning of equity?

Equity, in the financial sense, represents ownership in a company. This can be ownership in a private company or shares in a publicly traded company. By owning equity, you become a shareholder, which means you have a say in some of the company's decisions and can benefit from its successes.

Whether you're considering buying stocks for the first time or just curious about how owning a part of a company works, learning about equity can open up a world of financial opportunities.

Read on to learn about equity in detail, its features, types of equity, how shareholder equity is calculated, and more.

Features of Equity

Voting Rights

As a shareholder, you may get the right to vote on important decisions, such as who makes up the board of directors. For example, if you own shares in a well-known company like Infosys, you could decide its leadership during the annual general meeting by voting in the election of board members. With this involvement, you can directly impact the company's strategic direction, making your investment about more than just financial returns.

Residual Claims

In the event of liquidation, after all liabilities have been settled, equity holders have a residual claim on the remaining assets. If a company goes bankrupt, whatever assets are left after paying debts will go to the shareholders.

Profit Participation

Shareholders might receive dividends, a share of the company's profits. This is a common practice among many companies that choose to distribute a portion of their earnings back to their investors.

For example, if you hold 100 shares in a company like HDFC Bank and it declares a dividend of ₹5 per share, you would receive ₹500 as dividends. 

How Does Shareholder Equity Work?

Shareholder equity, or owner's equity, is a crucial measure of a company's net value. It is calculated by subtracting total liabilities from total assets. This figure is important as it shows the value that shareholders would theoretically receive if the company were liquidated. The formula mentioned below will help you understand this better. 

Formula for Calculating Shareholder Equity

Shareholder equity = Total assets − Total liabilities

Here is an example to understand this better. If Tata Steel had total assets of ₹1.12 lakh crores and liabilities of ₹88,000 crores. This means the company’s shareholder equity will be:

₹1.12 lakh - ₹88,000 crores = ₹34,000 crores. 

The amount of ₹34,000 crores reflects the company's net value owned by its shareholders.

This formula helps evaluate a company's financial stability and operational efficiency. It is crucial to assess the company's true worth beyond its market valuation.

Types of Equity

Let's take a look at the different types of equity. Some of these are critical components of a company's equity, and others reflect internal corporate financial strategies:

1. Common Stock

It represents equity ownership in a company. Common stock comes with voting rights and a share in the company's profits. For example, if you own common stock in TCS, it means you own a part of the company and have voting rights equivalent to the number of shares you own.

2. Preferred Stock

Preferred stock offers priority over common stock in dividend payments and liquidation. This means you will receive dividends before common shareholders, and if the company is liquidated, you will be paid out first. However, preferred stock typically does not come with voting rights, so you won't have any say in company decisions. 

3. Retained Earnings

Retained earnings represent profits reinvested into the business rather than distributed as dividends to shareholders. This reinvestment supports growth and expansion by funding new projects, research and development, or paying off debt. By retaining earnings, companies can strengthen their financial position and pursue long-term strategic goals.

4. Additional Paid-In Capital

Additional paid-in capital is the extra money a company receives from shareholders over the par value of its stock. Suppose the par value is ₹10, but investors pay ₹15 per share, which means the additional ₹5 is paid-in capital. Investors pay more because they believe in the company's growth potential. Such additional shareholder investment helps the company raise funds without borrowing and supports its expansion efforts.

Advantages and Disadvantages of Investing in Equity Shares

Here's a look at the advantages and disadvantages of investing in equity shares:

Who Should Consider Investing in Equities?

Investing in equities or stocks demands careful consideration and a willingness to accept higher risk. It's ideal if you have a longer investment horizon, typically five years or more. Equities offer the potential for significant long-term growth if you're comfortable with market fluctuations and have the patience to stay put during downturns.

It's crucial to assess your risk tolerance before investing. Equities are subject to market volatility and can experience steep declines in value, as we saw during the COVID-19 pandemic and even the recent Lok Sabha election results. If you're risk-averse, you may consider allocating a smaller portion of your portfolio to equities and focusing more on stable assets like bonds.

Investing in equities is suitable for individuals seeking higher returns over the long term and who can tolerate market volatility. This includes younger investors with a higher risk tolerance and a longer time horizon, allowing them to ride out market fluctuations.