When you hear the term "equity," you might think of its uses in legal or social contexts; fairness or equality may come to mind. You may be familiar with home equity, which is a way to measure how much you have paid on your mortgage, compared to how much you owe. When used in the context of investing, "equity" has a unique definition. In fact, it has a few. It can describe shares of stock, the value of a company on its balance sheet, or a form of ownership in a private company.
In all of these cases, equity can reveal important information about a company or an investment, so it's important to know what each context implies. Here we'll cover the three main ways "equity" is used investing.
What Are the Ways "Equity" Is Used?
One way to think about equity in investing, as compared to how the word might be used in other fields, is to keep in mind that it refers to value. When you hear the term "equity" used when speaking about investing, it will be in one of three main ways:
- Equity or equities: Shorthand for a share (or shares) of stock or other securities
- Shareholder equity: The portion of value that shareholders own of a given company; also measured on the balance sheet by how much they would receive if the company were to pay all of its debts and distribute all of its assets
- Private equity: An asset derived from the value in an alternative structure of ownership for private companies
Although all types of equity are important to an investor, they mean very different things.
How Is 'Equity' Used to Talk About Shares of Stock?
The term "equities," when used in the plural, is shorthand for shares of common stock. You may also hear it used to refer to shares of preferred stock, which is simply a special, higher class of stock. These details aren't too crucial to have a good sense of the term, though. The thing to note is that if someone mentions their "equity portfolio," they're talking about their stock holdings.
Equities are securities that transfer a stake in ownership to the person who buys them. After you've bought any shares of, say, McDonald's stock, you can claim to own a (very small) piece of the chain.
What Does Equity Mean on the Balance Sheet?
In almost all cases, "equity," when used in the singular, refers to the broad concept of ownership in a company. To figure out how much ownership, or the value of that equity, you can look to a figure on the balance sheet—namely, shareholders' equity. This figure will tell you how much money will be left for owners of a company (which includes people who own shares of stock), if it were to use its current assets to pay its current debts. Equity in this sense can be positive or negative, and it can be a useful way to measure the financial health of a company. If a company made a ton of profits in years past, is sitting on plenty of cash, and owes very little, equity probably will be high. On the other hand, if a company lacks the money to pay off its debts, even after cashing in all of its assets, shareholder equity will be negative. That is typically a red flag for an investor.
What Can Equity Tell You About a Company?
Though equity is a crucial metric, you have to look at the full picture. For some businesses, shareholder equity is extremely important and useful to reveal what the company is truly worth. For instance, General Motors is a massive company that needs large manufacturing facilities to make its cars. It may be tricky to gauge value at any given moment, since there's so much that goes into the making of cars before seeing a profit. The company's assets might not be so much liquid cash, but mostly locked up in the value of machines and other equipment, which could be worth a lot.
For businesses that produce income without a lot of assets, the amount of equity listed on the balance sheet is not that useful. For instance, the software company Oracle needs very little other than programmers sitting at desks to create its software.
How Is Private Equity Unique?
The term "private equity" (PE) refers to an entirely different type of ownership structure from that of publicly traded equities. First of all, investing in private equity does not involve buying shares of company stock, as private companies do not trade over the counter or on a public stock exchange. Instead, private equity investors look to reap value from private companies through direct funding or through full buyouts of public companies with the intent to make them private. These are high-cost and high-stakes goals.
Can Anyone Invest in Private Equity?
People who invest in the PE market are big earners who can afford the high price tag on massive deals, and also the luxury of time. Private equity investing is a long game, and unlike with public stock that might rise and fall by the hour, profits often take years. But the payoffs can be huge. Those who take part are special PE or venture capital firms, or angel investors, often working hand-in-hand with law firms to broker deals. 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, who takes the partners' money and invests it in privately held companies.
Most PE owners are also so-called accredited investors, which means they have plenty of wealth, with money coming in, and can meet minimum net worth and income requirements, either alone or with a spouse.
How Does the Private Equity Market Work?
PE managers work to create value in a number or ways. One way is to reorganize businesses to be more efficient and profitable, and then sell them to buyers. Another way is to prepare a private company to go public, through an initial public offering (IPO) within five to seven years. No matter the method they use to create value, PE investors know that if they want to see a return on their investment, it will take a lot of money up front, and greater risk than if they were to deal in public trading markets.
Since the deals come with such high stakes, PE managers often focus on the field and method they know best. For example, certain PE 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 troubled companies and doing what it takes to make them profitable again. Some might work with companies of a specific size range and use one to roll up competitors to create a larger, more efficient enterprise. A savvy PE investor would choose which of these methods makes sense for them.
PE funds can consist of many deals, at varied stages, with more than one private company. For this reason, its crucial that PE investors be on the lookout for hidden fees and conflicts of interest.
Does Private Equity Include Venture Capitalism?
There is some overlap in the way PE investing and venture capital work, but they are not quite the same thing. PE investments most often consist of complete buy-out of a private company or deals that involve the acquisition of 100% of a company's equity during the restructuring phase.
Venture capital, on the other hand, most often involves taking only a partial stake in a private company. Small startups are the standard target of a venture capitalist; if they see promise, they can get in on the ground floor with a more modest investment. Since these companies are just starting out, there's no need for the massive reorganization or overhaul that PE deals usually consist of.
- The word "equity" can refer to a few things in the investing world: shares of stock, total shareholder value, or investing in private equity firms.
- "Equity" as shares of stock can also mean privately held stocks.
- "Total shareholder equity" refers to a company's balance sheet value and its ability to pay off its debts if it were liquidated.
- Private equity investing is done through a private equity manager and is usually distinct from investing in publicly traded companies.