Shareholder’s Equity

Shareholder’s equity is the residual claim on assets after settling claims of creditors. Shareholder’s equity is also called as stockholder’s equity, net worth, net assets, net book value or owner’s equity.

Shareholder's Equity = assets - liabilities

What are the sources of shareholder’s equity? The main sources of stockholder’s equity are a. Contributed Capital (arises from sale of shares) and b. Retained Earnings (arises from operations).

Contributed Capital:

The initial source of shareholder’s equity comes from sales of shares via IPO. The shareholder’s equity generated from an IPO will have two components, common stock (par value) and additional paid-in-capital. In addition to common stock and paid-in-capital, any stock repurchase by the company also adds up to shareholder’s equity.

There are only two things a public limited company can do with the money that it had generates from the  business. The company can re-invest the money back into the business in order to grow its business or  the company can return the money to its share holders. Now, there are only few ways a company can return the money to its shareholders. The company can issue dividends or it can repurchase your own share in the form of share buyback.

Share buyback directly increase the shareholders equity because, when you retire your own stock, your company’s total common stocks in the market goes down and therefore existing owners of the company will earn more earnings per share than they were earning before the buyback. Again share buyback doesn’t simply increase value for a share holder, it depends on an important attribute, the price at which the share buyback is announced.

Below is a reference from Warren Buffet in his 2016 Berkshire Hathaway shareholder letter about share repurchase.

In the investment world, discussions about share repurchases often become heated. But I’d suggest that participants in this debate take a deep breath: Assessing the desirability of repurchases isn’t that complicated.

From the standpoint of exiting shareholders, repurchases are always a plus. Though the day-to-day impact of these purchases is usually minuscule, it’s always better for a seller to have an additional buyer in the market.

For continuing shareholders, however, repurchases only make sense if the shares are bought at a price below intrinsic value. When that rule is followed, the remaining shares experience an immediate gain in intrinsic value. Consider a simple analogy: If there are three equal partners in a business worth $3,000 and one is bought out by the partnership for $900, each of the remaining partners realizes an immediate gain of $50. If the exiting partner is paid $1,100, however, the continuing partners each suffer a loss of $50. The same math applies with corporations and their shareholders. Ergo, the question of whether a repurchase action is value-enhancing or value-destroying for continuing shareholders is entirely purchase-price dependent.

– Warren Buffet

Any time we buy are sell a share of a public limited company, we have to remember that we are not just transacting a piece of security, we are actually owning a piece of business.  Every time we try to purchase or sell a piece of business, we have to ask ourself the question, “Why am I right?”. Answering this question is not simple. One, we have to assess the business – the domain it operates in, its future prospects, it’s pricing power, it’s ability to win the competitors and several other factors. Second, we have to assess the price of the purchased share in relation to the companies fundamentals and future prospects. One simple way to exercise discipline is to remember this below nugget whenever we try to own or try to depart from a business.

The fundamental fact about investing that nobody can ever forget is that whenever you buy a stock thinking it’s going to do to well, somebody else is selling it, thinking it’s going to do badly, and one of you is always wrong. So you always have to ask the question, “Why am I on the right side of this trade?” And this is a value approach to being on the right side of the trade.

– Prof. Bruce Greenwald

Retained Earnings:

Retained earnings is the accumulation of net income over the life time of the business. Net income is nothing but taking the revenue of the business and subtracting it from cost of doing business.

Retained Earnings = Retained Earnings at the beginning of the ear 
                    + Net Income
                    - Dividends

Summary:

The public limited company generates value to its share holders by increasing its shareholder’s equity over it’s life time. This is achieved by providing value to its customers via its product offerings. A successful business is the one that can attract customers and can price its product above the cost. This will only happen if the customers realizes a value in purchasing the product sold by the company. Such a company will generate a positive net income, which will result in increased retained earnings. The company can then use its retained earnings to expand its operations. The alternative is to go to the market, dilute it’s shares to generate the investment capital. When a business can successfully generate positive net income and use that generated income for its investment instead of diluting it’s shares, it can substantially increase it’s earning-per-share over its lifetime. As the earning-per-share goes up, the stock price will appreciate in the market benefiting the owners of the business, the companies share holders.

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