Common Equity: Everything You Need to Know
Common equity is the total of all investments from investors (including all common stock, retained earnings, and additional paid-in capital) in a company.4 min read
Common Equity: What Is It?
Common equity is the total amount of all investments in a company made by common equity investors, including the total value of all shares of common stock, plus retained earnings and additional paid-in capital. The measure of common equity does not include the value of preferred equity, that is, the value of preferred stock or any other related interest (limited liability units, or limited partnership interests) with preferred equity status.
Issues regarding equity investment in a company can be complicated. Potential investors are strongly advised to seek out the advice of professional legal and financial counsel before committing to any equity investment.
Common stock is one of two classes of securities issued by a company in the form of equity shares. (The other class is preferred stock) Both classes represent a degree of investor ownership in the company, but they also differ in several important ways. Common stock provides its owners with what is often termed a “residual” claim to a company’s income and assets. That is, when the proceeds from company profits are distributed, both lenders and preferred stockholders are paid before any payments are made to common shareholders. Other important differences between common stock and preferred stock include:
Common shareholders have voting rights in the company. Preferred shareholders do not.
Common stockholders may or may not be entitled to dividend payments. A lack of dividend payment on common stock may, however, be beneficial to common shareholders because set dividends can have a negative effect on total capital gains. Preferred stockholders are, in almost all cases, entitled to dividend payments, and dividend payments are always made to preferred shareholders before any are made to common shareholders.
Common stocks typically outperform preferred stocks and bonds over the long run.
In the event of a company’s failure, common stockholders have no claim to company assets until all debtors and preferred shareholders are paid.
Paid-in Capital and Retained Earnings
Paid-in capital is the amount of funds raised through investors when stock is issued, including par value of the shares. It consists of the funds raised in equity, but does not include funds from ongoing operations. Common equity includes all paid-in capital not derived from preferred equity.
Retained earnings are those earnings that are held back by the company to be reinvested in the company or to pay off debt, rather than paid out as dividends. Retained earnings, along with non-preferred related paid-in capital and common stock total value, are what make up common equity.
Why Is Common Equity Important?
Common equity is important for several reasons. Knowing the amount of a company’s return on common equity (ROCE), for example, provides potential common stock investors with a clear idea of the returns received by the common (voting) equity holders when preferred equity holders are not taken into account, information critical in deciding whether or not to invest in the company’s common stock. A simple formula for calculating ROCE is:
Net income (NI) - Preferred dividend value / Average common equity = ROCE
Common equity = Total equity - preferred equity
Average Common equity = Beginning common equity + Ending common equity / 2
Other ways in which common equity plays an important role in the life of a company include:
Common equity can be important to a startup by providing a way to compensate company founders and attract experienced professionals, in lieu of high salaries, when on-hand cash is limited.
Options for the purchase of common stock are often included in the compensation packages of company employees, thus providing those employees with an incentive to work hard for the company’s success. Common equity, in fact, provides an incentive to founders, employees and financiers alike to succeed because success will result in a higher value to common equity holdings.
Frequently Asked Questions
- What is “tangible common equity”?
Tangible common equity is a form of common equity that measures a company's capital in a way that is especially useful in valuing companies with large amounts of preferred stock. It is calculated by taking the company’s book value and subtracting its preferred equity, goodwill, and intangible assets.
- Do I have to issue anything other than common stock?
No. If you choose to issue only one type of stock, though, common stock will be it. In such a case, a company’s total equity will be equal to its common equity.
- Why do preferred equity holders enjoy certain “perks” over common equity holders, such as priority in the distribution of company profits?
The advantages enjoyed by preferred shareholders are balanced out by certain disadvantages, when compared to holding common stock. For example, unlike common shareholders, preferred shareholders do not have company voting rights and therefore have no direct say in how the company is run. Preferred shareholders additionally are not able to participate, to as great an extent as common shareholders, in higher returns when a company’s net worth increases.
- If founders divide up common equity at the start, how do others invest?
The value of your company’s common stock will change over time. As you issue additional shares to investors, the value of the initial shares will likely decrease. The lower value acts as an incentive for new investors to purchase your stock.
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