Technical / Capital
Equity: What Owners Actually Own
Equity explained: the residual claim shareholders have after all debts are paid. Core valuation concept for investment banking interviews.
"The first rule of an investment is don't lose money. The second rule is don't forget the first rule." — Warren Buffett
Concept
Shareholders' equity is the residual interest in a company's assets after subtracting all liabilities. On the balance sheet, it's the accounting plug—Assets minus Liabilities equals Equity. This isn't a market value or what investors would pay today. It's a historical record: capital contributed by shareholders plus earnings retained over the company's life, minus any capital returned through buybacks. For most companies, this book value bears little resemblance to market capitalization. But for banks, insurers, and asset-heavy industries, book equity remains the valuation anchor.
Intuition
The balance sheet must balance. Assets equal liabilities plus equity—always. This means equity isn't independently measured. It's derived. Whatever assets exceed liabilities, that's equity by definition.
Think of it as an accounting residual with economic meaning. Creditors have fixed claims. Shareholders own whatever remains. The balance sheet captures this subordination in a single line: shareholders' equity is the buffer between assets and liabilities.
This residual nature explains why book equity can be negative. If accumulated losses exceed contributed capital, liabilities exceed assets, and shareholders' equity turns negative. The company isn't necessarily insolvent—it may have valuable intangibles not on the books—but the accounting equity is underwater.
Components
Shareholders' Equity Defined
What It Is
Shareholders' equity is the residual claim on a company's assets after all liabilities are paid. It appears at the bottom of the balance sheet, completing the fundamental accounting equation:
Rearranged:
Interview Script
Equity is the residual claim on a company's assets after all liabilities are paid—it's what shareholders own after creditors get their fixed claims. On the balance sheet, it's calculated as Assets minus Liabilities, representing contributed capital plus retained earnings minus any capital returned through buybacks. It's important to note this is book value, not market value—for most companies, book equity looks nothing like market cap.