Debt, Cash and Shareholders' Equity

Shareholders' equity, also called stockholders' equity or book value, is what would theoretically remain for shareholders if a company sold all its assets at their balance sheet values and paid off all its liabilities. It is the bottom section of the balance sheet. Equity grows when a company earns profits and keeps them, and shrinks with losses, dividends and share buybacks. It is the basis for ratios such as price to book and return on equity.

The formula#

shareholders' equity = total assets - total liabilities

Components of equity#

How equity changes#

ending equity = beginning equity + net income - dividends - buybacks + shares issued ± other comprehensive income

Book value per share#

book value per share = shareholders' equity / shares outstanding

Investors compare the stock price with book value per share using the price to book ratio. Banks and insurers are often valued this way because their assets are mostly financial and marked close to market value. See Price to Sales and Price to Book.

Tangible book value#

tangible book value = equity - goodwill - intangible assets

Tangible book value removes assets that may be hard to sell in a crisis. It is especially watched for banks. See Goodwill and Intangible Assets.

Negative equity#

Equity can become negative when liabilities exceed assets. This happens for different reasons:

Several well known, highly profitable companies, such as some restaurant chains and consumer brands, have had negative equity because they returned more cash to shareholders than they had accumulated in retained earnings. For them, negative equity does not mean distress, but it does make return on equity meaningless. See Buybacks.

Equity and return measures#

Return on equity (ROE) is net income divided by equity. High ROE can reflect strong profitability, or simply low equity due to buybacks and debt. Analysts use ROIC alongside ROE to avoid this distortion. See ROE, ROA and ROIC.

Limits of book value#

• Historical cost accounting means many assets are recorded below their current value (land bought decades ago) or above it (outdated equipment).
• Internally created intangibles such as brands and software are mostly missing.
• Buybacks reduce book value even when they create value for shareholders.

Equity and dilution#

Issuing new shares raises equity on the balance sheet but spreads ownership across more shares, so existing holders own a smaller slice of the company. Employee stock compensation, convertible bonds and secondary offerings all add shares over time. Comparing book value per share, not just total equity, shows whether shareholders are actually better off. See Secondary Offerings and Rights Offerings.

Frequently asked questions#

What is shareholders' equity?#

Total assets minus total liabilities, representing the book value that belongs to shareholders.

What is retained earnings?#

The cumulative net income a company has kept in the business rather than paying out as dividends.

Can shareholders' equity be negative?#

Yes. It can result from accumulated losses, which is concerning, or from large buybacks and dividends funded by debt at profitable companies, which may be less concerning.

Next, learn the principles of valuing stocks in Valuation Basics.