Shareholders’ equity: What does it mean and why is it so important?

“Book value is the amount you paid for an asset, minus its depreciation. “

Equity

Equity or book value represents the shareholder’s interest in a company and represents the value of its assets that are not financed by debt. Book value is nothing more than equity per share.

Equity = Total assets – total liabilities

As the formula above suggests, if you take the carrying value of the assets and subtract liabilities, what rests are those assets that are not financed by debt. Sometimes referred to as “net assets”. (net assets = the assets attributable to the shareholders)

So if the company gets liquidated, all assets would be sold. The amount of cash acquired by selling the assets would first be used to pay off debt. What remains of the money would usually be paid out to the investors.

So if a company has $1.000.000 in assets and $600.000 in liabilities its equity would be $400.000.

$1.000.000 – $600.000 = $400.000

And its debt to equity ratio would be 1.5.
($600.000/$400.000 = 1.5)

So in the example above, the company has 1.5 dollars in debt for every dollar it owns.

 

Assets, Liabilities and Shareholders’ equity can be found on the balance sheet.

Value indicators

Now that you know the importance of equity, you should also know what to look out for.

Here are some key metrics to look at when searching through companies:

  • Price to Book value: Price to book value tells an investor how much he has to pay for every dollar of equity.For example; A company with a price to book value ratio of 1.5 tells the investor he has to pay 1.5 dollars for every dollar of equity he gets. This does also mean if the company gets liquidated, the investor would only get back 1 dollar for every 1.5 dollars he paid.
  • Debt to equity: How much debt does the company have in comparison to its equity? We usually like to see anything around or below 0.5. This would mean the company has only 50 cents of debt for every dollar in equity it owns.Or in other words how much of the company is financed by loans due to creditors, banks, and bondholders in comparison to the amount invested by shareholders (shareholders = owners of the company).Other important metrics you find here.

Watch out

Equity (or book value) is not only backed by tangible assets but also by intangible assets like goodwill, which can easily lose their value when a business goes bust. In some cases, an investor will calculate the “tangible book value”. This is the value of the tangible assets, assets that can be sold at their fair market value.

In order to find the tangible book value, an investor would look at the “asset” section on the balance sheet and add all the amounts of intangible assets (such as; goodwill, patents, franchises, trademarks,..) together and subtract them from the total book value amount.

Intangible book value = Total amount of book value – the accumulated value of intangible assets

 

So book value is an important number to look at. However, no single measure tells the whole story about the company. If you want to learn how to read financial reports, this could be a good start.

 

 

 

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