What is Equity

Introduction

This tutorial provides a comprehensive understanding of equity, covering its significance in accounting, home ownership, investing, and startup financing. By breaking down the concept into manageable sections, you will gain clarity on how equity functions across different contexts and its implications for financial decision-making.

Step 1: Understanding Equity in Accounting

• Definition: In accounting, equity represents the owner's claim on assets after liabilities are deducted. It's reflected on the balance sheet.
• Accounting Equation: The fundamental equation is:

  Assets = Liabilities + Equity
  

  This means:

  Equity = Assets - Liabilities
  

• Changes in Equity:
  • Increase: Equity increases when a company is profitable, as net income is added to retained earnings.
  • Decrease: Equity decreases due to losses or when dividends are paid to shareholders.

Step 2: Equity in Home Ownership

• Concept: Equity in home ownership is calculated as the market value of the home minus the mortgage balance.
• Example:
  • Home value: $500,000
  • Mortgage: $400,000
  • Equity: $500,000 - $400,000 = $100,000
• Factors Affecting Equity:
  • Paying Down Mortgage: Reducing the mortgage increases equity.
  • Market Value Changes: If the home value increases, equity increases. If it decreases, equity may become negative, necessitating discussions with the bank about remediation.

Step 3: Investing in Equity

• Investment Options:
  • Debt (Bonds): Fixed interest rates and collateralized by assets (e.g., machines).
  • Equity (Stocks): Higher potential returns but also greater risks.
• Total Return Tracking: Use online tools like Sharesight to track the total return on your stock portfolio, which includes share price changes and dividends.

Step 4: Equity in Startups

• Valuation Challenge: Startups often lack physical assets, making valuation based on projected revenues, profits, and cash flows essential.
• Investment Appeal: Investors look for potential growth, and successful startups may attract significant funding.
• Cultural Reference: The series "Silicon Valley" offers insights into the dynamics of startup equity and valuation.

Conclusion

Understanding equity is crucial across various financial domains, from accounting and home ownership to investing and startups. Recognizing how equity is calculated and what factors influence it will empower you to make informed financial decisions. Consider tracking your investments and staying updated on market trends to maximize your equity potential.