Have you decided to invest in company shares? To understand how lucrative it will be once you become a common shareholder, you must use common equity to estimate ratios and projected returns. So what is common equity?
The amount common shareholders have invested in a company retained earnings and additional paid-in capital is known as common equity. It represents the amount of money a company’s shareholders would receive during liquidation or acquisition.
Common equity is a vital step every potential investor and brokerage looking forward to investing in a promising company must take, especially when preparing a strategy. Let’s learn more.
What Is Equity?
New investors ought to ask one crucial question: what is common equity if they want to succeed in their new job path? But they must understand what equity is. Equity, also referred to as shareholders’ equity, is the money shareholders would receive if the company liquidated its assets. In case of acquisition, the shareholders would receive the amount remaining after the company settles all the debts.
Additionally, shareholder equity also represents a company’s book value and can be found on a company’s balance sheets. Equity shareholder is a piece of crucial information used by investors to assess a company’s financial health and its capability to offer tangible returns.
In other posts, you can read more about small-cap stocks and penny stocks, while here we focus on several types of equity which include:
- Treasury stock
- Common stock
- Contributed surplus
- Preferred stock
- Retained earnings
Is Common Equity the Same as Total Equity?
Common equity is not the same as total equity but before we look at the differences, let’s first understand what equity is. Equity means stock or shares. In other words, equity is the total net amount of the capital company owners have injected. You can derive equity by deducting a company’s total assets and liabilities.
Common Equity
Common equity is the total shares belonging to the company’s shareholders and founders. In other words, common equity is the number of investments held by investors in terms of ordinary shares, additional paid-in-capital, and retained earnings. But, preferred shares, limited liability units, and interests related to preferred equity statuses are not part of common equity.
If a company’s assets are liquidated, which is something that hardly ever happens to blue-chip companies though, the investor’s common equity will remain after settling the company debts. On the other hand, shareholders receive the amount after liabilities are deducted from the value of company sales during acquisition.
Equity common shareholders have the right to vote as they are partial owners of the company. Although they deserve to receive the profit share, they only get their share once they have settled preferred shareholders. But, when a company’s net worth increases (see Canada Nickel), they enjoy higher returns than preferred shareholders entitled to a fixed percentage.
Total Equity
Total equity is the total shares belonging to the founders and shareholders. It is the addition between preferred and common equity. To calculate, one should deduct total liabilities from total assets. Investors can get their total asset and liabilities information from its financial statements.
Total equity is calculated by adding ordinary shareholders, retained earnings, premium shares, and preference shares and deducting the dividends.
Total assets include accounts receivable, cash, non-current assets, marketable securities, goodwill, and prepaid expenses.
On the other hand, total liabilities include; long-term debt, short-term notes, unearned revenue, accrued liabilities, accounts payable, and other liabilities.
What Is Return on Common Equity?
Return on common equity(RCE) is a company’s net income or profits regarding the invested dollar. RCE only applies to common shareholders. Investors return on common equity to see common shareholders’ returns without including other shareholders.
In other words, return on common equity weighs a company’s ability to use its investment dollars to generate returns. Common investors can also track the reinvestment of their capital through return on common equity. Although investors always go for the best companies with a high return on common equity, it is essential to compare with the industry’s average.
The reason is, not all companies recording high returns on common equity make sound investment decisions (as an investor you can ask one of robo advisors for financial advice). Companies can derive the return on common equity by dividing the net income by average common equity.
To find average common equity, one has to add the years beginning common stock and the ending common stock. The total is then divided by two. The company’s balance sheets contain this information.
How Do I Calculate Common Equity?
Investors rely primarily on common equity before any trade of shares in a particular company. Therefore, knowing how to calculate common equity is a crucial move. A shareholder needs surplus capital, common stock, and retained earnings to calculate common equity.
- Common stock: You can determine common stock from a company’s balance sheet. To get the desired figure, multiply outstanding common stock by the stock’s face value. If the company does not state its common stock on the sheets, deducting retained earnings from total equity will help determine the common stock.
- Capital Surplus: capital surplus can be defined as surplus after the common stock is sold out higher than its par value. Capital surplus is on the balance sheet under additional paid-in capital or (APIC).
- Retained earnings: company’s retained earnings are the income retained after a company pays dividends to the shareholders. Retained earnings are below the stockholder’s equity section. It is under the title retained earnings on the income statement.
For example: If a company has 20,000 shares and a face value of $10 per share, its common stock will be 200,000. Let’s also assume the company’s capital surplus to be 25,000 and 30 000 in retained earnings.
Common equity= common stock+ surplus capital+ retained earning
Common equity in our case will be: 200, 000+25,000+30,000= 255,000
What Is Company Tangible Common Equity?
Company tangible common equity is a company physical capital measuring unit used to determine financial institution capabilities in dealing with potential losses. When calculating tangible common equity, preferred equity and intangible assets are deducted from the book value.
A financial institution can increase its tangible common equity by moving its preferred shares into common shares. In most cases, tangible common equity is a conservative measure of stability as it is used to calculate the capital adequacy ratio to evaluate a financial institution’s solvency.
What Is Common Stock Equity?
Common stock is a security representing the owners of a company. Common stock is also known as an ordinary share, common share, or voting share. In addition, common stock owners can elect members of the board and vote on critical corporate policies. They also have the right to claim a stake in their profits.
Common stock equity holders enjoy huge dividends when the company makes more returns than preferred stockholders who get a fixed amount. However, in liquidation, common stockholders only have the right to company assets after other shareholders receive their share, a risk they have to take. Companies report their common stock on the stockholder’s equity location on the balance sheet.
A company must have an initial public offering(IPO) before it begins the process of issuing common stocks to the public. An IPO helps companies willing to seek additional funds. But before kickstarting an IPO, a company must close collaboration with an underwriting bank.
The bank’s responsibility is to help determine the type of stock and its price. After a successful IPO process, the public can purchase the new common stocks.
The Bottom Line
Investing in and trading with company shares is a bold move that requires a closer look at the company’s financial growth and stability. Analyzing a company’s common stock is very crucial for investors. Common stock value gives a clear understanding of the returns investors are likely to receive in the liquidation or acquisition process.
To calculate common equity is very easy. One needs to add the company’s retained earnings, surplus capital, and common stock. The company’s financial statement includes all this information.
