Stockholders' Equity: Formula & How It Works
Stockholders' equity is the value of assets a company has remaining after eliminating all its liabilities. Companies with positive trending shareholder equity tend to be in good fiscal health. Those with negative trending shareholder's equity could be in financial trouble, especially if they carry significant debt.
What Is Stockholders' Equity?
Stockholders' equity, sometimes referred to as "owner's equity,” “shareholders' equity, or "book value (of equity)," is calculated by subtracting a company's total liabilities from its total assets. If a company was forced to liquidate, its shareholders would have rightful ownership over the remaining equity share, which is the value of assets remaining after all liabilities have been extinguished.
Stockholders' equity is a line item that can be found on a company's balance sheet, and the trend in stockholders' equity can be assessed by looking at past balance sheet reports.
- Companies with positive and growing stockholders' equity are usually viewed as financially stable.
- Negative stockholders' equity, when a company's liabilities exceed the value of its assets, may be an indication of financial struggles and a greater risk of declaring bankruptcy.
However, shareholders' equity alone may not provide a complete assessment of a company's financial health.
Stockholders' Equity Formula
The formula for calculating stockholders' equity is:
Stockholders' Equity = Total assets – Total Liabilities
The financial data necessary for the formula can be found on the company's balance sheet, which is available in its annual report, or its quarterly 10-K report filed with the Securities and Exchange Commission. A balance sheet lists the company's total assets and total liabilities for the most recent period.
Assets
- Total assets are the sum of a company's current assets and non-current assets.
- Current assets, such as cash, accounts receivables, and inventory, are assets that can be converted to cash within one year.
- Non-current, or long-term assets, such as property, equipment, and intangibles (i.e., patents), are often not easily converted into cash within one year.
If a company does liquidate, less marketable assets may yield lower sales proceeds than the value carried on the most recent balance sheet. The stockholders' equity account is by no means a guaranteed residual value for shareholders if a company liquidated itself.
Liquidity
- Total liabilities are the sum of a company's current liabilities and long-term liabilities.
- Current liabilities include short-term debt such as accounts payable and taxes payable.
- Longer-term liabilities typically repaid over periods longer than one year include bond debt, pension obligations, and leases.
Important: Total assets and total liabilities are itemized on the company's balance sheet, followed by a statement of stockholders' equity.
Calculating Stockholders' Equity
Balance sheets are displayed in one of two formats, two columns or one column. With the two-column format, the left column itemizes the company's assets, and the right column shows its liabilities and owner's equity. A one-column balance sheet lists the company's assets on top of its liabilities and owner's equity. In both cases, the resulting stockholders' equity is at the bottom.
In the below example, the company's total assets can be calculated by adding current assets ($89,000), Investments ($36,000), non-current assets ($337,000), intangible assets ($305,000), and other assets ($3,000). Total Assets are thus listed at $770,000.
Below that, current liabilities ($61,000) are added to long-term liabilities ($420,000) in reaching a total liabilities number of $481,000. Total stockholders' equity is $289,000 in the example, equal to total assets of $770,000 less total liabilities of $481,000.
Source: AccountingCoach
An alternative way to calculated stockholders' equity is through adding the company's book value common stock value ($110,000), retained earnings ($220,000), other accumulated comprehensive income, minus the value of treasury stock. The net result from this calculation is also $289,000.
Multi-Year Balance Sheets
Multi-year balance sheets help in the assessment of how a company is performing from one year to the next. In the example, this company had experienced a significant year-over-year increase in total assets, from $675,000 to $770,000. However, this change was offset by a substantial increase in total liabilities, from $380,000 to $481,000. Since total assets rose $95,000 versus a $101,000 increase in total liabilities over the period, the company's stockholders' equity account actually dropped in value by $6,000.
Important: Stockholders' equity is calculated via the accounting numbers on a company's balance sheet, and thus reflects the book value of equity. A company's market value of equity can differ substantially from the stockholders' equity value, and often does.
How Stockholders' Equity Works
The original source of stockholders' equity is paid-in capital raised through common or preferred stock offerings. The second source is retained earnings, which are the accumulated profits a company has held onto for reinvestment. For established companies who have accumulated substantial profits over time, retained earnings could be the largest contributor to the stockholders' equity value, especially if the company hasn't reduced its equity through the payment of dividends or the repurchase of stock through share buybacks.
Initially, at a corporation's foundation, the amount of stockholders' equity reflects how much co-owners or investors have contributed to the company in form of direct investments. The capital invested enables a company to operate as it acquires assets, hires personnel, and creates operations to market, produce, and distribute its products or services. Investors hope their equity contributions can be paid back to them through dividends and/or increase in shareholder value. Some investors may be repaid directly by the company via share buybacks.
Retained earnings are part of the stockholders' equity equation because they reflect profits earned and held onto by the company. Profits contribute to retained earnings, while losses reduce shareholders' equity via the retained earnings account. Companies in the growth phase of their business can use retained earnings to invest in their business for expansion or boost productivity. Also, companies that grow their retained earnings are often less reliant on debt and better positioned to absorb unexpected losses.
Low Stockholders' Equity
Low or declining stockholders' equity could indicate a weak business, and/or a dependency on debt financing. However, low or negative stockholders' equity is not always an indication of financial distress. Newer or conservatively managed companies may have lower expenses, thereby not requiring as much capital to produce free cash flow. Companies that distribute and increase regular dividends may also have lower stockholders' equity because they are rewarding shareholders through the distribution of profits rather than retaining this capital for growth.
Important: Just because a company's stockholders' equity is low doesn't mean it is in financial distress. Companies with lower expenses may not require as much capital to generate cash flow.
Components of Stockholders' Equity
Understanding the components that comprise stockholders' equity can help investors focus on the underworkings that affect its value from one year to the next.
1. Retained Earnings
Retained earnings represent the cumulative amount of a company's net income that has been held by the company as equity capital and recorded as stockholders' equity. Some net income may have been distributed outside the corporation via payment of dividends. Essentially, retained earnings represent the amount of company profits, net of dividends, that have been reinvested back into the company.
While newer companies rely on the initial paid-in capital to fund operations and growth initiatives, the accumulated retained earnings of more established companies can be the largest source of stockholders' equity.
2. Paid-In Capital
For many companies, paid-in capital is a primary source of stockholders' equity. Paid-in capital is the money companies bring in by issuing stock to the public. It is reflected on the balance sheet as the total amount of equity over the par value of the stock. Additional paid-in capital, which is often shown as APIC on the balance sheet, reflects funding a company has received by issuing new shares.
Some companies will issue debt to expand their businesses. A debt issue doesn't affect the paid-in capital or shareholders' equity accounts.
3. Treasury Shares
Companies may conduct a share buyback, especially if they are unable to productively use equity capital for growth opportunities. Any stock repurchased is identified as Treasury Shares. While Treasury Shares are counted as issued shares, they are no longer counted as outstanding shares, and aren't factored into
earnings per share ((EPS)) or dividends-per-share calculations. Companies can either:- Repurchase shares, which would reduce stockholders' equity and increase the share count in the Treasury, or
- Retire shares entirely if they don't expect to need them for future financing. Retiring treasury stock reduces the number of a company’s shares issued.
4. Common Stock
A company's total number of outstanding shares of common stock, including restricted shares, issued to the public, company officers, and insiders is a key driver of stockholders' equity. The amount recorded is based on the par value of the common and preferred stock sold by the company not the current market value. Par value is the issue price of shares. This figure is reduced when the company repurchases its shares.
Stockholders' Equity Example
A company's shareholders' equity is fluid, often changing several times during a year due to actions taken by the company, which can affect one or more of the components.
Retained Earnings
When a company generates net income, or profits, and holds on to it rather than pay it out as dividends to shareholders, it's recorded as retained earnings, which increase stockholders' equity. For example, if a company reports $10,000,000 in net profits for the quarter and pays $2,000,000 in dividends, it increases stockholders' equity by $8,000,000 through the retained earnings account. If a company reports a loss of net income for the quarter, it will reduce stockholders' equity.
Paid-In Capital
When a company needs to raise capital, it can issue more common or preferred stock shares. If that happens, it increases stockholders' equity by the par value of the issued stock. For example, if a company issues 100,000 common shares for $40 each, the paid-in capital would be equal to $4,000,000 and added to stockholders' equity.
Treasury Shares
When a company buys shares from its shareholders and doesn't retire them, it holds them as treasury shares in a treasury stock account, which is subtracted from its total equity. For example, if a company buys back 100,000 shares of its common stock for $50 each, it reduces stockholders' equity by $5,000,000.
Common Stock
The total number of outstanding shares of a company can change when a company issues new shares or repurchases existing shares. It should be noted that the value of common and preferred shares is recorded at par value on the balance sheet, so the amount shown doesn't necessarily equal or approximate the company's market value.
Takeaway: A company's stockholders' equity can fluctuate due to its activities that affect retained earnings, paid-in capital, or the number of its treasury shares and outstanding stock.
Statement of Stockholders' Equity
A Statement of Stockholders' Equity is a required financial document issued by a company as part of its balance sheet that reports changes in the value of stockholders' equity in a company during a year. The statement provides shareholders with a summary view of how the company is doing. It's also used by outside parties such as lenders who want to know if the company is maintaining minimum equity levels and meeting its debt obligations.
Source: Seeking Alpha
Line items listed in the statement include the company's opening balance of stockholders' equity carried over from the end of the prior year's statement, net income (from the income statement), other income, paid-in capital, net loss, dividends, and capital withdrawals.
Calculations Involving Stockholders' Equity
Understanding stockholders' equity, how it works, and how it's calculated can help investors gauge how a company is doing. However, stockholders' equity doesn't provide a complete picture of a company's performance and how effectively it is managing and creating stockholders' equity. Incorporating the stockholders' equity figure into financial ratios can add insightful dimensions to a company evaluation. One of the more valuable ratios is Return on E
quity (ROE).Return on Stockholders' Equity
Return on stockholders' equity, also referred to as Return on Equity (ROE), is a key metric of company profitability in relation to stockholders' equity. Investors look to a company's ROE to determine how profitably it is employing its equity. ROE is calculated by dividing a company's net income by its shareholders' equity.
ROE = Net Income After Tax / Shareholders' Equity
Assessing whether an ROE measure is good or bad is relative, and depends somewhat on what is typical for companies operating within a particular sector or industry. Generally, the higher the ROE, the better the company is at generating returns on the capital it has available.
Return on Assets
Another key metric for gauging a company's performance is
Return on Assets (ROA). ROA and ROE are similar in that they both measure how well a company's investments generate value for shareholders. ROA considers all assets, including debt, and is calculated as follows:ROA = Net Profits / Average Total Assets
Bottom Line
Stockholders' equity is the value of a company directly attributable to shareholders based on in-paid capital from stock purchases or the company's retained earnings on that equity. While it's an important financial metric on its own, incorporating the stockholders' equity into financial ratios, such as return on equity, provides a more detailed picture of how a company is managing its equity.
This article was written by
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours.
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