The financial world can be confusing. It can often feel like you need to swallow a whole financial syllabus just to get started, which can put many people off from looking at ways to make their money go further. Equity is a concept you’ll encounter early on, but it’s multiple meanings can make it difficult to understand.
Instead of putting your future financial security at risk by assuming it’s something you’ll never understand, here we help you get to grips with the concept by breaking down what equity really means, how it works, and how you can make it work for you.
What is equity?
Representing the real value of an investors stake in an investment, equity is important. In general terms, equity is the value of an asset after factoring in all of its liabilities (financial debt or obligations).
In finance, equity refers to a person’s ownership of an asset after the liabilities have been made off. This could be your family home after the mortgage has been paid off, for example. In theory, you could readily sell your home with no debt in between you and the sale.
If you wanted to sell your property but were still paying off your mortgage, your equity would be the amount you receive after you’ve sold the property and have paid off the mortgage.
We explain how to calculate equity in a bit more detail below.
Types of equity for normal investors
When investing, equity is usually used to refer to a person’s ownership of shares in a business.
There are three basic types of equity for normal investors to choose from:
- Common stock
- Preferred shares
- ETF shares
Common stock represents a level of ownership in a corporation, stockholders will receive dividends (payments) on any capital gains (profit) made, based on the number of shares they hold.
Preferred shares are units in a business that have a higher claim to the earnings and assets of the business that normal stock. In most cases, preferred shares have a dividend that take priority over normal shares.
A drawback for investing in single companies is that you can be overly-exposed to its performance. That’s great if the business does well, but bad news if it things don’t go to plan. That’s why investors look for diversification with their investments to manage this risk. But diversification is a difficult thing to get right yourself, not to mention expensive.
A simple, low-cost and transparent way to achieve diversification, Exchange Traded Funds are essentially a basket of investments that aim to replicate an index, specific commodity, bond, or basket of assets.
ETFs are simple investment vehicles. As they’re traded over an exchange, they act like a share on the stock market. ETFs have a bid and ask price – the point at which a buyer wants to buy and a seller wants to sell. Their price fluctuates throughout the day as they are bought and sold by investors. Importantly, you can trade an ETF in seconds.
This provides investors with transparency and flexibility, which can be essential for families that feel alienated from the traditional financial system.
Private equity
Instead of investing through an exchange, private equity involves investors that specifically invest in private companies, or takeover public companies with the eye of doing them up and floating them back on the stock exchange for a profit.
Private equity can be crucial to a business at different stages of its life. It could be a new company with no revenue that needs to borrow money from angel investors to grow, or a company with a product that needs to raise money from venture capitalists to bring its service to market.
Private equity isn’t for the average investor, you’ll need at net worth of $1 million to be accredited in the first place. But this doesn’t mean equity can’t help you reach your goals nonetheless.
Calculating equity
If you’re struggling to remember the concept, you might find its anagram somewhat refreshing; ALE. Assets – Liabilities = Equity.
If you’re working this out for a company, you should be able to find all the information you need in the balance sheet, although remember to include both short-term and long-term assets and liabilities.
Shareholder equity is used by analysts to judge the financial health of a company. Representing the net value of the company, it essentially calculates how much will be returned to shareholders if all the assets were cashed in and debts repaid.
Shareholder equity can be both positive and negative, with the latter generally being seen as much riskier investments.
You may also calculate shareholder equity through the following equation:
Share capital + Retained earnings – Treasury Shares = Equity
Share capital is the total value raised from issuing both common and preferred lines of stock. Retained earnings is the profit a business doesn’t pay out in dividends, but keeps to either reinvest in the business or pay off debt. Treasury shares are kept by the company itself, either through share buy-back schemes or as part of a float.
Investing in equities
Equities is also used as a term to describe a whole asset class, along with fixed income and cash equivalents.
Equities are seen as the riskier asset class with the potential for the highest returns. Before investing in equities you need to consider the risk associated with your specific investment, as well as wider economic risk, interest rate risk, foreign-exchange risk, geopolitical risk and the impact of taxes.
You’ll also need to consider how fees and charges will impact your returns, as well as the impact of compounding and pound cost averaging.
Equities, fixed income and cash equivalents are used in the process of asset allocation to build portfolios that are suitable for an investor’s risk profile, time horizon and goals.
Diversifying your investments in line with your risk tolerance means you can manage the risk in your portfolio by spreading your money across asset classes. Asset classes rarely go up and down in sync with one another; therefore, having exposure to a range of asset classes limits the risk impact of any one asset class.
Building the right portfolio to help you reach your goals can be a difficult thing to get right, especially when you’re juggling your career, the school run and your hobbies.
Luckily, Moneyfarm does this for you, matching you to an investment portfolio that’s built to reflect your investor profile and time horizon. The hardest thing you need to do is decide when you want to invest, and with how much.
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