Many investors almost completely ignore the financial statements that companies report. Yet it's important to understand the ins and outs of companies in which you invest, and knowing the basics of the balance sheet is a great way to start. In particular, the concept of stockholders' equity carries clues to the true value of a company. Let's get more familiar with what you'll find in this part of the balance sheet.
A simple definition for stockholders' equity
The easiest way to understand stockholders' equity is to see it as what's left over when you take the rest of the balance sheet into account. A company's assets are usually straightforward to understand, and the liabilities it owes to others are real obligations that help the company in its business pursuits. Mathematically, when you take the value of a company's assets and subtract out the value of its liabilities, what's left is stockholders' equity.
What you'll find under stockholders' equity
On the balance sheet, what gets listed as stockholders' equity typically falls into two categories. One category represents the amounts that investors voluntarily contribute toward the company's capital, typically by making investments in exchange for shares of the company's stock. The other category comes from the operations of the company itself.
Stockholders' equity from capital contributions can show up in several ways. The Common Stock line item seems like the natural place to put such contributions, but that line typically only reflects the nominal par value of each share of stock that the company issues. As a result, it dramatically understates the actual contributed capital in most cases. What typically happens is that any excess received from investors gets put into a separate line known as Paid-In Capital. In addition, if the company buys back stock that it has previously issued, it can show up in an entry called Treasury Stock.
You'll primarily see the impact of operations on stockholders' equity in one line item: Retained Earnings. If a company earns a profit and doesn't pay it all out to shareholders in the form of dividends, then the excess will get added to Retained Earnings and boost stockholders' equity. If a company has unrealized gains and losses on its income statement, they will often show up not in Retained Earnings but rather in Accumulated Other Comprehensive Income. However, those figures tend to cancel each other out, while Retained Earnings steadily rises in most successful companies.
Looking at a balance sheet might not sound like the most interesting thing to do, but it can greatly enhance your understanding of companies in which you invest. Learning what stockholders' equity is and what goes into it will help you gain insight into how companies become successful.
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