3 Financial Definitions of Equity

••• Roberto Westbrook

One of the financial terms you are likely to encounter many times along your investing path is "equity." The word can have three different meanings for investors, so it's important to know the context in which it's being applied to determine the correct definition.

1. "Equities" as a Synonym for Shares of Stock

The term "equities," when used in the plural, is universally shorthand for shares of common stock, though you will sometimes also hear it used to refer to shares of preferred stock, which are often convertible into common stock. If someone mentions their "equity portfolio," they're talking about their stock holdings.

Equities are securities that confer an ownership stake to the holder. After you've purchased, say, 1,000 shares of McDonald's Corp., you can claim you own a (very small) piece of the restaurant chain.

2. "Equity" as a Balance Sheet Concept

In almost all cases, "equity," when used in the singular, refers to the broad concept of ownership or a balance sheet accounting value—namely, shareholders' equity. This figure lets an investor know how much money is left for owners of a business if all accounting liabilities are subtracted from all accounting assets. Note that shareholder equity is not the same as net tangible assets, or book value, because net tangible assets excludes intangible assets such as goodwill while shareholders' equity includes them.

For some businesses, shareholders' equity is extremely important and useful in determining what the company is truly worth. For other businesses—those that don't require a lot of assets to generate income—balance sheet equity is of limited utility. An example of the former would be General Motors Co., which needs large manufacturing facilities to make its cars. An example of the latter would be Oracle Corp., which relies on programmers sitting at desks to create its software.

Some investors may use the term "equity" loosely to mean "assets minus liabilities" in a way that does not technically align with proper accounting. It's especially true in the world of real estate. For example, a real estate investor might say they have $400,000 of equity in a home with a market value of $1 million and an outstanding mortgage of $600,000.

3. "Equity" as Part of "Private Equity," a Specialized Type of Investment Structure

The term "private equity" refers to an entirely different type of ownership structure than that for publicly traded equities. If someone talks about their private equity holdings, it usually means they have a stake in a limited partnership or some other legal entity that is run by a private equity manager. The private equity manager takes the partners' money and invests it in privately held companies that are not traded over-the-counter or on a stock exchange

Private equity managers usually reorganize businesses with the intention of either selling them to another buyer or exiting through an initial public offering within five to seven years. In exchange for sacrificing liquidity and taking on greater risks, private equity investors expect, but do not always experience, higher returns on their investment than investors in publicly traded equities.

Private equity managers frequently specialize. For example, certain private equity managers may prefer to take over packaged food companies. Some might be experts in completing leveraged buyouts, placing loads of debt on their target businesses. Some might have experience in turnarounds, taking a troubled company and restoring it to profitability. Some might work with companies in a specific size range and use one to roll up competitors to create a more efficient, larger enterprise.

Private equity is usually differentiated from venture capital in that private equity typically involves the total acquisition of 100 percent of a company's equity during the restructuring phase, while venture capital usually involves taking a partial stake in a highly promising start-up company. Private equity owners usually must be so-called accredited investors, who are capable of meeting minimum net worth and/or income requirements, either alone or in combination with a spouse.

Private equity is also differentiated from hedge funds in that many hedge funds focus on investing in ("going long") or betting against ("shorting") publicly traded equities, though some also do private-equity-type deals.