3 Financial Definitions of Equity
One of the financial terms you are likely to encounter many times in your investing career is "equity". As a basic concept, it is important you understand not only the definition, but how the definition might vary based upon context. Here are three important definitions you should keep in mind:
1. Using "Equities" as a Synonym for Common Stock
The term "equities", when used in the plural, is universally shorthand for shares of common stock, though you will sometimes hear it used to refer to preferred stock, particularly preferred stocks that are convertible into common stock. In other words, it is effectively synonymous with common stock and is merely a linguistic preference. For example, if you heard someone say the sentence, "I invest in real estate, although I do hold some equities in my portfolio." What they are saying is: "I invest in real estate, although I do hold some common stocks in my portfolio." It is important to understand that equities are a type of security but not all securities are equities.
When discussing individually managed accounts for affluent and high net worth investors, you might encounter multiple types of equity strategies. Some of these include:
- Large Cap Core Strategies that focus on buying the largest, most stable blue chip stocks in the United States
- Equity-Income Strategies that focus on acquiring higher-quality common stocks that pay dividends
- Equity Index Strategies that seek to mimic or in some way replicate a stock market index
- High Dividend Yield Strategies that focus on acquiring stocks with higher-than-average dividend yields
- Dividend Growth Strategies that focus on buying stocks with dividends that are growing much faster than the typical stock
- Long/Short Equity Strategies that attempt to provide positive absolute returns over time with lower volatility than the stock market as a whole
- International Equity Strategies that build an investing methodology around acquiring stocks in a specific country or region. This can overlap with equity index strategies. For example, the MSCI EAFE, one of the most popular equity indices, "is designed to represent the performance of large and mid-cap securities across 21 developed markets, including countries in Europe, Australasia and the Far East, excluding the U.S. and Canada. The Index is available for a number of regions, market segments/sizes and covers approximately 85% of the free float-adjusted market capitalization in each of the 21 countries."
The same is true of mutual funds. Mutual funds that invest exclusively, or nearly exclusively, in common stocks or other equity securities are called equity funds. You can find out about a mutual fund's investment mandate by reading the mutual fund prospectus. Most of the big-name index funds, such as those that follow the S&P 500 stock market index, are equity funds, although index funds exist for non-equity asset classes such as bonds, too.
2. Using "Equity" to Refer to 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, quite, exactly the same as net tangible assets or book value, as net tangible assets requires taking shareholders' equity and backing out intangible assets such as Goodwill.
For some businesses, shareholders' equity is extremely important and useful in determining what the company is worth. For other businesses, particularly those that don't require a lot of assets to generate income, balance sheet equity is of limited utility. An excellent example of the former at the time I wrote this article is Berkshire Hathaway, Inc.; of the latter, a major software company such as Microsoft or Adobe.
It is important to acknowledge that many investors use the term "equity" loosely to mean "assets minus liabilities" in a way that does not technically align with proper accounting. For example, if you encounter a real estate investor, he or she might say, "That property has a market value of $1,000,000 and I carry a $600,000 mortgage against it, leaving me $400,000 in equity."
3. Using "Private Equity" to a Specialized Investment Structure and Philosophy
The term "private equity" refers to an entirely different type of ownership experience than publicly-traded equities and, when used by knowledgable investors, financial journalists, and academics, comes with an implicitly understood constellation of built-in expectations and assumptions. 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 major stock exchange.
Private equity managers usually reorganize businesses, including making changes to the firm's capital structure, with the intention of selling the business either to another buyer or exiting through an initial public offering (IPO) 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 plain-vanilla 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. 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 it to rollup 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 (ownership) 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" 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 blend the distinction between this and private equity. Since we discussed Berkshire Hathaway a moment ago, an excellent demonstration of this hybrid model: the Buffett Partnerships through which Warren Buffett amassed the initial capital that allowed him to build one of the largest personal fortunes in global history.
The Buffett Partnerships routinely acquired not only publicly-traded stocks, but control positions in other businesses that allowed management to treat those entities like private equity investments.