Stockholder Equity on the Balance Sheet
We've arrived at the shareholders' equity section of the balance sheet. Shareholders' equity represents the stockholders' claim to the assets of a business after all creditors, liabilities, and debts have been paid. In laymen's terms, it represents net worth. Shareholders' equity is also referred to as owners' equity or stockholders' equity.
There is a lot of important information in the shareholders' equity section so you're going to want to pay special attention as it can help you understand the quality of a firm's economic engine when used in conjunction with other figures, especially those from the income statement as well as provide some insights into the form and nature of its capital structure.
How Shareholders' Equity Arises on the Balance Sheet
When looking at a balance sheet, shareholders' equity usually comes from two sources.
- Cash or other assets paid in by investors when the company was raising capital in exchange for issuing shares of common stock or preferred stock
- Retained earnings, which are the accumulated profits a business has held on to and not paid out to its shareholders as dividends or used in the repurchase of stock, either for shares that were retired or those held in a special section of shareholders' equity called treasury stock, which has the effect of reducing retained earnings.
Shareholders' equity is adjusted for a number of additional items. For example, there is a section called "Other Comprehensive Income", which includes things like valuation allowances for changes in the market value of certain securities or investments held in certain classified ways as well as cumulative translation allowances on foreign currency as it pertains to assets and liabilities.
Depending upon the specific business, whether or not, and how, important these items are will vary greatly so there's no substitute for diving into the annual report and Form 10-K filing to read the disclosures and explanations, piecing together an understanding of the way the accounting reflects economic reality.
To provide one illustration, imagine you were looking at the shareholders' equity section of a property and casualty insurance company. With several balance sheets in front of you, going back years, you're probably going to need to pay attention to the unrealized gains and losses on investments that show up here and how they are influenced by minority interest accounting rules, particularly the cost method, equity method, and consolidated method.
Investors Have Changed How They Look at Shareholders' Equity Over Time
A century ago, it was common practice for investors to believe that the more shareholders' equity on the balance sheet, the better. In fact, investors paid attention to how much shareholders' equity they were getting on a per share basis, decrying companies without a lot of tangible assets in the figure as being "water".
Today, we know a lot better. If you are investing in bank stocks, sure, more shareholders' equity is ideal because even though it may lower return on equity, it means a bigger margin of safety in the event losses develop in the loan book; more equity to absorb bad debts that aren't repaid either due to poor underwriting or a general economic recession or depression.
For a lot of businesses, though, the less shareholders' equity, the better. In some cases, shareholders' equity doesn't have much meaning at all because it doesn't take much money to produce each dollar of surplus free cash flow, so the enterprise can scale and throw off wealth for owners much more easily. Imagine the maker of a popular phone or tablet game; a team of young developers who set up a limited liability company and work from their home.
Once the initial software is created, little of which required shareholders' equity as it was mostly bootstrapped from the founders and developers putting in their time, it doesn't take any net worth to produce income. The game is on the various platforms where players can buy it or process transactions for in-game purchases and nearly all of the revenue is unrestricted free cash flow if the business is well-run and structured correctly.
If it becomes a hit, it'd be possible for millions of dollars in income to be produced from practically no shareholders' equity at all. It's a very different thing than something like a railroad, which requires huge expenditures such as railroad track and railcars.