This section of the balance sheet represents the total value that is attributable to the owners (shareholders), after deducting all the obligations of the company, i.e. what portion of the assets is left for the shareholders after the company pays all its dues – to creditors (banks, bond holders), employees (pensions and salaries), taxes (accrued tax) etc. Thus, it is shown as below in mathematical form:
Shareholders’ equity = Total assets – Total liabilities
A lot of sub-headings come under this category, such as – Common stock, Retained earnings, Treasury stock and Other items (could be various form of reserves set aside by the company). As an investor, we are mainly concerned with the following two categories:
- Retained earnings: This line item shows the accrual of reinvested income over the years. Let’s say a company makes a net income of $50k in the 1st year and distributes $10k to the shareholders as dividend. Remaining $40k is reinvested in the business, and this amount is added to the Retained earnings. In the second year, net income grows to $80k, out of which $30k is distributed to the shareholders. The remaining $50k is reinvested in the business, thus increasing the Retained Earnings to $90k ($40k + $50k) by end of second year.
- Treasury stock: When a company starts buying back its shares in the market, it gets the shares back. Now it can either choose to keep them as Treasury stock in Equity section, or just cancel them out completely. Keeping them accounted for gives a flexibility to re-issue shares later to raise more capital if needed. If the shares are not cancelled, they sit on the company’s books as Treasury stock. These shares neither have any voting rights and nor any right over the earnings of the business, i.e. when the net income per share is calculated, these shares are excluded from the calculation. Do we like to see Treasury stock on the balance sheet? Yes, if the management buys the stocks back at a price lower than the intrinsic value of the business or, if the management thinks that it can’t deploy the excess capital in a manner that would increase the return for the shareholders. If the management is not able to find good projects to invest in, it can decide to return cash to the shareholders via dividends or share buybacks. Share buybacks are usually more tax-efficient way of returning cash to the shareholders, hence many investors like to see companies buying back shares.
Please note that sometimes a portion of reinvested capital can be accounted for under various categories within the Shareholders’ equity section. Some of these earnings can be allocated FX exposure buffer, which is there just to prevent loss from currency fluctuations effecting the business activities. All in all, what we really want to see is that the retained earnings and other buffers have been increasing consistently.
The value of Treasury stock can significantly lower the value of shareholders’ equity as it is carried in the balance sheet as a negative number. For such companies doing share-buybacks, you can add back the value of Treasury stock to remaining shareholder’s equity to see the trend of shareholders’ equity over the years.