Balance Sheet

Definition of Shareholders Equity

Shareholders equity represents the net worth of a company after deducting all liabilities.  Shareholders equity, or owners equity, can be derived by using values from the balance sheet. 

A companies initial public offering (IPO) of common stock and preferred stock is the means to acquiring the funds to expand operations and grow the company.  This is the first form of shareholders equity and the other is retained earnings.  Retained earnings are net profits from operations which have not been paid out as dividends and will be re-invested into the company.

Calculate Shareholders Equity

Shareholders equity can be calculated in one of two ways:

Difference between Shareholders Equity and Book Value

Some tend to confuse shareholders equity with the book value of a company.  These two concepts are not the same due to the fact that book value adjust to exclude all intangible items, such as goodwill.  Book value is only concerned with the true value of all physical, tangible items, such as computers and office equipment to name a few.

What is Treasury Stock?

The term treasury stock refers to common shares which have been repurchased or reacquired through the open market by the issuing company.  This action will reduce the float, or number of common shares outstanding.  It can also be common shares which were not issued to the public during the initial public offering (IPO) for the purpose of being able to sell the shares at some point in the future when cash is needed.

The amount of treasury stock held by a company can be easily found on the balance sheet as a line item, within the Shareholders Equity section.

There is heavy debate as to whether or not this line item should be listed as an asset on the balance sheet.  It can be readily re-issued in the open market; however, due to the disadvantages listed below, those against listing treasury stock as assets believe they have no added economic impact or benefit which would be required to be defined as an asset

Why Do Companies participate in Stock Buybacks?

A company may elect to buyback shares for a couple of reasons.  Firstly, it may believe that they are undervalued by the market and therefore will buy the shares back with the hopes of re-issuing them at some point in the future when prices are more favorable.  Other reasons include incentivizing employees with company stock rather than cash and buying back enough shares to prevent a hostile takeover bid.

Disadvantages of Treasury Stock

It is important to understand that treasury stock does not carry voting privledges, dividend payments, nor does it have any right to any assets during liquidation.  Additionally, each state will have laws governing the percentage of shares that a company may hold in treasury.

The motives of the company during a buyback should be understood as well.  If the company is buying back stock to positively impact their financial ratios such as the EPS or price to earnings ratio, a company is doing a dis-service to their shareholders as there is an attempt to mislead. 

What are Retained Earnings?

When a company turns a net profit, they can elect to either pay it out as a dividend or take these earnings and reinvest them back into the company.  In the case of the latter, the company will record these earnings as retained earnings which will be recorded on the balance sheet under shareholders equity.  If the company turns a net loss for the reporting period, the loss decreases the retained earnings balance.

Investors will closely monitor the usage of retained earnings by management to determine if the funds are being used appropriately.  If they do not see a significant return on investment, investors will demand that they be paid a dividend instead of reinvesting the earnings.

Uses of Retained Earnings

For many companies, retained earnings will be used to expand their business model; while for others, it is used as a means for acquiring new equipment or servicing existing equipment.  For this reason, investors would rather be paid out in dividends; it typically takes the company a very long time to recover a decent return on invested funds when they are used for such expenses. 

Smaller, high growth companies are prime candidates for putting retained earnings to good use.  Typically, investors will encourage these companies to reinvest into high growth, high yielding investments.

Generally speaking, the easiest way to measure the return on the use of retained earnings to measure the change in the price of the common stock against the amount of retained earnings per share utilized to achieve this gain.  Obviously, this return is questionable as stocks can be trading at levels which are at a large premium or discount to the book value of a company. 

Calculating Retained Earnings

Retained earnings can be calculated by using the following formula:

RE = Retained Earnings from Prior Period + Net Income - Dividends Paid