If you’ve been investing for a while, you’ve probably heard the term “equities.” Let’s explore what it means and why people call stocks “equities.”
Start with the equity in a house. If your home is worth $400,000 and you owe $320,000 on the mortgage, it has $80,000 of equity. The building is the asset and the mortgage is the debt.
Equity = Assets - Debt (liabilities)
Equity works the same way in the stock market, except it’s more complicated because companies have all kinds of assets. They manage products with changing customer bases. They own facilities and equipment across multiple states or countries. They have intellectual property that’s difficult to value. Ups and downs in the economy can also have big impacts on their performance.
As a result, most uncertainty in the stock market centers around valuing a company’s assets. How much profit will they generate? Is there competition? What happens if there’s a recession?
The Power of Business Ownership
These are the kinds of questions business owners ask. And that’s the key thing equities provide: ownership in a business.
Owning stocks means you own pieces in a business. There are advantages and drawbacks.
The advantages include flexibility and ease. It’s not easy to get a job at innovative technology firms like Apple (AAPL) or Facebook (FB). But it only takes a few clicks of the mouse to buy their shares. Separating yourself by selling them is just as simple.
Thinking about stocks like a job might seem new, but it makes when you consider the old saying that “time is money.” Consider this as an equation:
Time = Money
Money = Time
We all know that time well spent now can become money later. But it’s also true that money well invested now can become time later (in retirement). One of the most effective ways to buy time later now is by owning solid businesses now. Then they can work for you over time.
Another advantage of ownership is that other people — or companies — might see value in the business you own. That’s what takeovers and mergers are all about. Owning shares lets you profit alongside high-ranking executives and founders when their firms get acquired.
The main drawback of ownership is the possibility of business getting worse. There’s also risk of declines in the broader stock market.
What is Residual Value?
The textbooks often say that stocks control the “residual value” of companies. This makes sense based on the formula above because equity is “what’s left over” after debts are paid off.
Residual value is an older concept from the days of railroads and canals. A company might borrow to lay track or purchase vessels. If they failed to pay their debts on time and went bankrupt, the assets still had value.
In modern times, it can be more useful to think about “enterprise value” instead.
Enterprise Value = Market Capitalization + Net Debt (Debt - Cash)
In the example of the house above, $400,000 is the enterprise value. $320,000 is the debt. Therefore $80,000 is the equity, or market capitalization. (The formula uses “net debt” because companies often have borrowings and cash on hand.)
Similar logic applies to businesses. Assets like buildings and product lines have certain values. Executives can finance those assets with varying amounts of debt. More debt results in less market capitalization, or less equity.
More debt also means there’s more leverage. Most people understand this with the house. If it appreciates to $440,000 (10 percent), the equity increases $40,000 (50 percent). The same logic applies in the stock market. More debt can increase leverage. That can also result in more volatility.
What is Preferred Stock?
You’ll also probably hear the term “preferred stock.” This is another old concept from the railroad days that’s lost a lot of relevance in the tech-powered economy.
Preferred stock isn’t equity because it doesn’t control residual value. Preferred shares are essentially bonds that the company can skip paying interest on without triggering bankruptcy. They’re called “preferred” because they must be given “preference” before the company pays dividends to ordinary shareholders.
Some preferred stock can also be “convertible” into stock, like convertible bonds. These are much more similar to equity. But they’re also complex instruments that may not be suitable for most retail investors.
In conclusion, stocks are called equities because they represent ownership in companies. They let investors benefit from growth but also have risk when business conditions weaken. Next time, we’ll explore the differences between stocks and bonds.
This article was written by David Russell, TradeStation Securities, Inc., part of the Monex Group Inc, published on 21/10/2020.
David Russell is VP of Market Intelligence at TradeStation Group. Drawing on nearly two decades of experience as a financial journalist and analyst, his background includes equities, emerging markets, fixed-income and derivatives. He previously worked at Bloomberg News, CNBC and E*TRADE Financial. Russell systematically reviews countless global financial headlines and indicators in search of broad tradable trends that present opportunities repeatedly over time. Customers can expect him to keep them appraised of sector leadership, relative strength and the big stories – especially those overlooked by other commentators. He’s also a big fan of generating leverage with options to limit capital at risk.