Common equity is the total value of ownership participation invested in a company.
Shareholding implies ownership. Thus, investors holding common equity can vote for or against the company’s directors, and they can sell their shares whenever they want. They’re also entitled to dividends when the company declares them.
In the accounting equation
The accounting equation shows the relationship between how much property a firm has, what it owes, and how much its owners’ interests are worth. Textbooks usually express the formula this way:
Assets = Liabilities + Equity.
Applying a little algebra, though, it becomes:
Equity = Assets – Liabilities.
Viewed from that angle, equity is everything the company has, minus everything it owes.
Claims on the company’s future earnings, though, drives valuation. As long as cash flows are strong and investors believe they’ll keep getting stronger, the price of a share is likely to grow. As it does, the common equity holder’s stake grows in value. That’s in addition to any returns from dividends paid.
Meanwhile, investors who bought the company’s bonds continue to receive interest payments of equal amounts, spaced exactly six months apart. Investors who extended loans to a real estate project sponsor will get their monthly payments. If the company grows or the project succeeds, the interest payments remain the same. And if the company hits hard times, that doesn’t affect the debt payments either.
If the company goes broke, though, debt holders’ claims come first. Common equity’s value could go to $0 and shareholders could lose all their money. Still, court-appointed receivers would sell off all assets to pay those creditors as much as they can.
Thus, common equity offers the most upside, but also represents the most risk.
Incidentally, common equity shouldn’t be confused with preferred equity, which is a special kind of capital that has characteristics of both equity and debt.
More about common equity
In a publicly traded corporation, common equity refers mainly to the value of the shares of common stock. However, it also includes retained earnings and additional paid-in capital. Retained earnings are the profits available to reinvest in the business or pay out as dividends in the future. Sometimes a corporate treasury has taken in more cash than the total par value of the outstanding shares. That’s additional paid-in capital.
Although common equity is a riskier investment than debt, there is one risk that it lowers. That is, of course, the risk of holding too much debt. Regulators worldwide require banks to hold a certain amount of their investments in common equity to keep them from becoming over-leveraged. A bank lending to a real estate investor or any other enterprise might place similar covenants on its borrowers.