The Lowdown on Stockholders’ Equity
Stockholders’ equity represents the portion of a company’s assets that remains after we subtract all liabilities. Think of it as the owners’ residual claim on the company. This equity section primarily consists of two key parts: Contributed Capital and Earned Capital.
Contributed Capital: The Money from Investors
This capital comes directly from stockholders’ investments in the company. We can break it down into a few main areas:
Common Stock:
This is the most fundamental type of stock. It gives shareholders ownership and voting rights. A share can have a “par value” (a small, nominal value) or “no par value.” Any amount a company receives for the stock above its par value is recorded as “additional paid-in capital.”
- For example, consider a company that issues 10,000 shares of common stock with a par value of $1 for $20 per share. The company’s cash increases by the full amount of $200,000 ($20 x 10,000 shares). On the balance sheet, the company records only $10,000 (10,000 shares x $1 par value) as common stock. The remaining $190,000 then becomes “additional paid-in capital” because investors paid that amount over and above the stock’s par value.
- Note: While this example separates Common Stock and Additional Paid-in Capital to clarify the concept, many companies present these as a single line item, often labeled “Common stock and additional paid-in capital,” on their financial statements.
Preferred Stock:
This stock is “preferred” because it gives owners certain advantages over common stockholders. For instance, preferred stockholders generally receive fixed dividends before common stockholders. In a liquidation, they also have a higher claim on the company’s assets. While preferred stock usually has a par value that helps calculate its fixed dividend, it typically does not have voting rights. Consequently, investors often choose preferred stock for its predictable income stream, whereas common stock owners value their ability to vote on company matters.
Earned Capital: The Company’s Earnings
This is the capital a company has accumulated over time through its operations. Its main components are:
- Retained Earnings: This represents the portion of a company’s net income that management chooses not to distribute as dividends. Instead, the company “retains” it to reinvest in the business, pay down debt, or use for other purposes.
- Accumulated Other Comprehensive Income (AOCI): This section includes various income and expenses that bypass the income statement, such as unrealized gains or losses on specific investments.
Repurchasing and Selling Stock
Companies do not just issue new stock; they can also buy back their own stock from the open market. This process is called a stock repurchase or buyback, and it creates a special category called Treasury Stock.
- When a company repurchases stock, it decreases its cash and stockholders’ equity.
- If the company later re-sells this treasury stock, it increases its cash and contributed capital.
These transactions are important because they directly affect the number of shares outstanding, which, in turn, influences the stock’s price and various financial metrics.
To see a stock repurchase in action, imagine a company buys back 2,000 of its common shares for $30 per share.
- The company’s cash decreases by $60,000 ($30 x 2,000 shares).
- At the same time, its Treasury Stock increases by the $60,000 cash paid. While this seems like an increase, companies record Treasury Stock as a negative number that reduces total stockholders’ equity.
Re-selling of Stock Illustrated
Case 1: Re-selling for a Profit
Now, let’s assume the company re-sells these same 2,000 shares for $32 per share.
- The company’s cash increases by $64,000 ($32 x 2,000 shares).
- We then decrease the Treasury Stock account by the original cost of $60,000. The company records this amount on the balance sheet with a positive sign because re-selling treasury stock increases capital.
- Consequently, the company’s Additional Paid-in Capital increases by the $4,000 difference between the re-sale price and the repurchase cost ($64,000 – $60,000). The company does not record this amount as revenue on the income statement; instead, it treats this transaction as a capital increase.
Case 2: Re-selling for a Loss
In contrast, what if the company re-sells the 2,000 shares for just $28 per share?
- The company’s cash increases by $56,000 ($28 x 2,000 shares).
- It still decreases the Treasury Stock account by the original cost of $60,000. We also record this amount on the balance sheet with a positive sign.
- However, because the re-sale price is lower than the repurchase cost, the company’s Retained Earnings decrease by the $4,000 loss ($60,000 – $56,000). The income statement does not record this loss as an expense; instead, retained earnings directly absorb the loss.
Understanding Treasury Stock
When a company repurchases its own stock, these shares become “Treasury Stock.” Although they are issued shares, they are no longer “outstanding” or “in circulation” because the company holds them.
- Balance Sheet Impact: While companies record the value of Treasury Stock, they present it as a negative number that reduces total stockholders’ equity. This is because a stock repurchase represents a return of capital to shareholders, not an investment by the company.
- No Voting Rights: Treasury Stock does not carry voting rights. When a company buys back its shares, the total number of outstanding voting shares decreases. As a result, the ownership percentage of the remaining shareholders can indirectly increase, which is a key motivator for a buyback.
- Reasons for a Stock Buyback: Companies repurchase their own stock for several reasons:
- Increasing Shareholder Value: By reducing the number of outstanding shares, a company can increase key financial metrics like Earnings Per Share (EPS), which often makes the stock more attractive to investors.
- Consolidating Ownership: Repurchasing shares helps a company maintain control and reduce the risk of a hostile takeover.
- Employee Compensation: Companies often use treasury stock to fund employee stock option programs.
- Returning Cash to Shareholders: A buyback is a tax-efficient way to return excess cash to shareholders, as it is generally taxed as a capital gain rather than a dividend.
Book Value vs. Market Value
Finally, it is important to distinguish between the book value and market value of a company’s equity.
- Book Value of Equity: This value is based on the company’s balance sheet. We calculate it by taking total stockholders’ equity and subtracting the value of preferred stock. In essence, it is the accounting value of the company.
- Market Value of Equity: This value is what the stock market places on the company. We calculate it by multiplying the number of outstanding shares by the current market price per share.
The market value is often significantly higher than the book value, reflecting investors’ expectations for a company’s future growth and profitability.
Why This Matters to a Non-Accountant
Understanding these financial concepts is not just for accountants—it is a powerful skill for any business professional or investor.
Evaluating a Company
The stockholders’ equity section shows how a company finances itself. By looking at a balance sheet, you can see if the company’s value comes from a strong foundation of retained earnings (profit) or from a history of issuing stock to raise cash.
Making Informed Decisions
As an employee, manager, or potential investor, understanding stock buybacks and their impact on EPS helps you interpret the company’s strategy. Is management trying to boost the stock price, or does it signal they lack better growth opportunities?
Gaining Business Acumen
Knowledge of equity helps you better interpret news, company reports, and investor presentations. You can look past the surface-level numbers to ask smarter questions about the company’s financial health and future plans. Ultimately, this helps you speak the same language as executives and financial analysts, which is a huge asset in any business environment.