Definition and Example of Equity in Investing
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. Equity can be the amount of ownership a stockholder has in a company, which is kind of like the amount of ownership, or equity, a homeowner has in a home they are paying a mortgage on.
Private equity occurs when an individual or a private equity firm invests in a private company. For example, a private equity firm may give a private company an infusion of capital to build the company. In exchange, the private equity firm will receive equity in the private company, unlike stocks received when investing in a publicly traded company.
How Equity in Investing Works
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. 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 corporation.
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.
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 Private Equity in Investing Works
The term "private equity" (PE) refers to a different type of ownership structure from that of publicly traded equities. Private equity investing 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.
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.
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.
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.
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.
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, who can get in on the ground floor with a more modest investment if they see promise. 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.