Shareholders Equity is the difference between a company’s assets and liabilities, and represents the remaining value if all assets were liquidated and outstanding debt obligations were settled.
Once all liabilities are taken care of in the hypothetical liquidation, the residual value, or “book value of equity,” represents the remaining proceeds that could be distributed among shareholders.
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Shareholders’ equity is the residual claims on the company’s assets belonging to the company’s owners once all liabilities have been paid down.
Under a hypothetical liquidation scenario in which all liabilities are cleared off its books, the residual value that remains reflects the concept of shareholders equity.
The fundamental accounting equation states that the total assets belonging to a company must always be equal to the sum of its total liabilities and shareholders’ equity.
If shareholders’ equity is positive, that indicates the company has enough assets to cover its liabilities. But if it’s negative, that means its debt and debt-like obligations outnumber its assets.
While there are exceptions—e.g. dividend recapitalization—if a company’s shareholders’ equity remains negative and continues to trend downward, it is a sign that the company could soon face insolvency.
If we rearrange the balance sheet equation, we’re left with the shareholders’ equity formula.
The formula to calculate shareholders equity is equal to the difference between total assets and total liabilities.
Shareholders Equity = Total Assets – Total LiabilitiesOtherwise, an alternative approach to calculating shareholders’ equity is to add up the following line items, which we’ll explain in more detail soon.
Shareholders Equity = Paid-In Capital + Retained Earnings + Accumulated Other Comprehensive Income (AOCI) – Treasury Stock
The shareholders’ equity line item on the balance sheet is composed of several items, with the main ones defined in the chart below:
Often referred to as paid-in capital, the “Common Stock” line item on the balance sheet consists of all contributions made by the company’s equity shareholders.
When companies issue shares of equity, the value recorded on the books is the par value (i.e. the face value) of the total outstanding shares (i.e. that have not been repurchased).
However, the issuance price of equity typically exceeds the par value, often by a substantial margin.
The excess value paid by the purchaser of the shares above the par value can be found in the “Additional Paid-In Capital (APIC)” line item.
Note: As a standard modeling convention, APIC is typically coupled with “Common Stock”.
Next, the “Retained Earnings” are the accumulated net profits (i.e. the “bottom line”) that the company holds onto as opposed to paying dividends to shareholders.
For mature companies consistently profitable, the retained earnings line item can contribute the highest percentage of shareholders’ equity. In these types of scenarios, the management team’s decision to add more to its cash reserves causes its cash balance to accumulate.
As a side benefit, the issuance of a dividend to shareholders can be perceived as a positive signal by the market that management is confident in the future profitability of the company, especially because dividends are rarely cut once announced.
In contrast, early-stage companies with a significant number of promising growth opportunities are far more likely to keep the cash (i.e. for reinvestments).
To calculate the “Retained Earnings” line item, the equation consists of:
The “Treasury Stock” line item refers to shares previously issued by the company that were later repurchased in the open market or directly from shareholders.
After the repurchase of the shares, ownership of the company’s equity returns to the issuer, which reduces the total outstanding share count (and net dilution).
Since repurchased shares can no longer trade in the markets, treasury stock must be deducted from shareholders’ equity.
But an important distinction is that the decline in equity value occurs due to the “book value of equity”, rather than the market value.
In recent years, more companies have been increasingly inclined to participate in share buyback programs, rather than issuing dividends.
Another benefit of share buybacks is that such corporate actions can send a positive signal to the market, much like dividends, without the obligation to maintain the repurchases (e.g. a one-time repurchase).
From the viewpoint of shareholders, treasury stock is a discretionary decision made by management to indirectly compensate equity holders.
The way equity holders benefit is that earnings per share (EPS) increases from a lower share count, which can often lead to an “artificial” increase in the current share price (and market capitalization) upon a share repurchase.
The shareholders equity ratio measures the proportion of a company’s total equity to its total assets on its balance sheet.
By comparing total equity to total assets belonging to a company, the shareholders equity ratio is thus a measure of the proportion of a company’s asset base financed via equity.
The shareholders equity ratio, or “equity ratio”, is a method to ensure the amount of leverage used to fund the operations of a company is reasonable.
Shareholders Equity Ratio = Total Shareholders Equity ÷ Total AssetsThere is a clear distinction between the book value of equity recorded on the balance sheet and the market value of equity according to the publicly traded stock market.
Now that we’ve gone over the most frequent line items in the shareholders’ equity section on a balance sheet, we’ll create an example forecast model.
To follow along, download the Excel file using the form below:
In our modeling exercise, we’ll forecast the shareholders’ equity balance of a hypothetical company for fiscal years 2021 and 2022.
Operating Assumptions (FY 2020A)
Considering the structure of roll-forward schedules—in which the ending balance of the current period is the beginning of period balance for the next year—the ending balances will link to the beginning balance cells.
Our first roll-forward schedule will be for the “Common Stock & APIC” line item.
Here, we’ll assume $25,000 in new equity was raised from issuing 1,000 shares at $25.00 per share, but at a par value of $1.00.
The APIC, which represents the excess value above the par value, can be calculated using the formula below:
In the next roll-forward projection, we’ll focus on the “Retained Earnings” balance,
Earlier, we were provided with the beginning of period balance of $500,000.
From the beginning balance, we’ll add the net income of $40,000 for the current period, and then subtract the $2,500 in dividends distributed to common shareholders.
As for the “Treasury Stock” line item, the roll-forward calculation consists of one single outflow – the repurchases made in the current period.
In 2021, the share repurchases are assumed to be $5,000, which will be subtracted from the beginning balance.
Note that the treasury stock line item is negative as a “contra-equity” account, meaning it carries a debit balance and reduces the net amount of equity held.
Lastly, for the “Other Comprehensive Income (OCI)” line item, we’ll assume the amount remains constant at $5,000 for both 2021 and 2022 (i.e. assumption is straight-lined).
In the final section of our modeling exercise, we’ll determine our company’s shareholders equity balance for fiscal years ending in 2021 and 2022.
To arrive at the total shareholders’ equity balance for 2021, our first projection period, we add each of the line items to get to $642,500.
If the same assumptions are applied for the next year, the end-of-period shareholders equity balance in 2022 comes out to $700,000.
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