Stockholders’ equity, or Shareholders’ equity, is the net worth of the company. Just like you and I calculate our networth as total assets minus total liabilities, a company’s net worth is also expressed as
Stockholders’ Equity = Total Assets – Total Liabilities
If this appears to be familiar, it is because this is the basic accounting equation, rearranged.
We will use the terms Stockholders’ Equity and Shareholders’ Equity interchangeably. Book value is another term for shareholders’ equity, that you may be more familiar with.
What does Shareholders’ Equity Mean?
The key insight is that the higher shareholders’ equity is better than a lower shareholders’ equity.
A positive stockholders’equity means that the company has sufficient assets to pay off all its liabilities. There will be value left over, and that value is what the shareholders expect to get in case of an orderly liquidation.
When a company has a growing shareholders’ equity, it implies that the company is generating profits and improving its position in the market. It does not however tell us whether the company stock is a good stock to buy, as this determination depends on the market price of the stock. The market price of the stock does not always follow the shareholders’ equity – sometimes it leads the metric, other times it lags the metric.
Price/Book Ratio is a good way to keep track of whether the stock price is rich or cheap compared to the stockholders’ equity.
What Affects the Stockholders’ Equity?
As can be seen, an increase in total assets will increase the stockholders’ equity. An increase in the total liabilities will cause a decrease in the stockholders’ equity.
If you look at a company as a closed system, i.e, a black box, it is easy to see that any money that is coming in either leaves the company or stays inside. If it stays inside, it grows wealth for the owners in the form of shareholders’ equity.
Money can come in via new financing (debt or equity), or via sale of products and services (revenues). Money can leave via payments for goods and services (cost of goods, employees, purchase of assets, etc) or via payout of a dividend to the shareholders.
Debt issuance does not change the stockholders’ equity, as it increases cash and therefore also increases the assets.
Purchase of new assets does not change the stockholders’ equity, as reduction in cash (or increase in debt) is counterbalanced with increase in physical assets.
Issuance of new stock will increase the shareholders’ equity. Similarly, repurchase of stock will decrease the shareholders’ equity.
Writing off debt will increase shareholders’ equity. Bad debts (uncollectable account receivables) will decrease shareholders’ equity. Inventory spoilage or theft will decrease shareholders’ equity.
Readjustment in asset values (mark to market) will change the shareholders’ equity.
However, the biggest contributor to the change in stockholders’ equity is the profit (or loss) a company generates via its business activities. A positive earnings increases shareholders’ equity, while a loss making enterprise will see its book value diminish over time.
When a company pays out a dividend, its shareholders’ equity goes down by the equivalent amount. However, if the company can cover its dividend with total earnings in excess of the dividend amount, the company will continue to grow its book value over time.
Earnings that are not paid out as dividends are retained in the Retained Earnings line of the Stockholders’ Equity section of the balance sheet.
How Should Value Investors Evaluate Shareholders’ Equity?
As value investors, we are very interested in the dynamics behind a number. While we can just take a ratio, such as P/B ratio, and call it a day, a good value investor will look at what is driving that number.
For example, a low P/B ratio can be a result of overstated book value on the company financials (and the market is aware of the problem). In this case, chasing the stock just because it has a low P/B ratio is foolish.
We often think of the investing world being made up of two types of fundamental investors:
- those who are primarily concerned with the balance sheet, and pay attention to the book value, and,
- those who are primarily concerned with the earnings and earnings growth, and do not pay enough attention to the book value or assets
As can be seen, both so called growth and value investors are actually joined at the hip in the form of the book value. Increasing earnings increases the shareholders’ equity, and vice versa.
Hopefully the above treatment gives you enough of an insight and you are now able to judge the stockholders’ equity number with a greater nuance.