Equity represents the owner’s interest in an asset or assets. If you own a home, your equity is the market value of your home minus the amount you still owe the financial institution that holds your mortgage. If you were to sell your home, the equity is the amount of money you would get to keep after paying off the mortgage (ignoring other fees that the seller might have to pay).
When you purchase stock of a company, you own part of that company. The market value of your equity is equal to the number of shares of stock you own times the market price per share of the stock. For example, if you purchase 100 shares of the common stock of Bank of America Corporation (BAC) at a price of $23.30, the market value of your equity at that point in time would be 100 x $23.30 = $2,330. If, two days later, the stock is selling for $24.00 a share, then the market value of your equity is 100 x $24.00 = $2,400.
So, where can you find this on the firm’s financial statements? You can’t. The financial statements of a firm are prepared according to Generally Accepted Accounting Principles (GAAP), which specifies that equity be recorded at its book value, which is different from its market value. The book value of the equity of a firm is equal to the book value of its assets minus the book value of its liabilities (i.e., debt). For the most part, these book values represent historical values. For example, the book value of land a company might own will usually equal the original cost of the land, even if that land was purchased 50 years ago.
Consider the following information from Bank of America’s balance sheet, as of December 31, 2019:
(millions of dollars)
Total assets $2,434,079
Total liabilities $2,169,269
Preferred stock $23,401
Common stock at par and additional paid-in-capital $91,723
Retained earnings $156,319
Accumulated other comprehensive income (loss) ($6,633)
Total shareholders’ equity $264,810
Total shareholders’ equity = total assets – total liabilities
$264,810 = $2,434,079 – $2,169,269
Note that this tells you nothing about the market value of the stock you own. Moreover, notice that there are a number of accounts listed under “shareholders’ equity.”
Some firms issue both preferred and common stock. About 88% of the preferred stock is issued by financial institutions, like Bank of America. Preferred stock is called “preferred” because these shareholders get paid before the common shareholders get anything if the firm is liquidated. They are also entitled to receive whatever dividend payment is due them before the common shareholders can be paid theirs. This said, their dividend payment is usually a fixed, stated amount, which means they won’t enjoy an increase in dividends even if the firm has an extremely good year. Preferred shareholders also typically don’t have voting rights as the common shareholders do.
The book value of the common equity is separated into three different accounts on the balance sheet: Common stock at par and additional paid-in-capital, retained earnings, and accumulated other comprehensive income or loss. The common stock at par and additional paid-in capital account indicates what the shares of the common stock originally sold for when it was issued. This is not its current market value.
The retained earnings account is a cumulative account. This account represents earnings that the firm has reinvested rather than pay out dividends. It increases each year by the amount the firm retains that year. For example, BAC’s 2018 retained earnings were $136,314 million. Subtracting this from the 2019 retained earnings of $156,319 million tells us that BAC reinvested $20,005 million of its 2019 income back into the firm.
The other comprehensive income or loss account represents revenues, expenses, and gains and losses that have been excluded from the net income reported on the firm’s income statement in accordance with GAAP standards because they have not yet been realized. These include items such as gains or losses on investments that the company is divesting which have not yet been sold and gains or losses on pension plans. Analysts can better evaluate a firm’s earnings and profitability by having this additional information reported.
In some instances, you might see another account listed in the shareholders’ equity portion of the balance sheet: Treasury stock. This account will only appear if the firm has at some point in time repurchased some of its outstanding shares from its shareholders. The value of those shares (at the time of repurchase) will appear in this account. Because it represents a repurchase of shares, shareholders’ equity will be reduced by that amount.
So, what does the value of the shareholders’ equity on the balance sheet tell you? Theoretically, it is the amount the shareholders would get once all the firm’s debt is paid if the firm is liquidated. Realistically, if a firm has reached that level of financial distress, there is usually nothing left for the shareholders. The same is often true when a firm files for bankruptcy and undergoes a reorganization. Typically, the existing shareholders receive nothing, and the existing debtholders become the new shareholders of the corporation, having received shares in partial compensation for the debt owed.