What is Residual Equity Theory?

The residual equity theory says that common shares make up the only true equity of a company. Preferred shares should be treated like a liability. Thus, the value of stockholder equity equals only the common shares. 

Residual Equity = Assets – Liabilities – Preferred Shares. 

This method of calculating shareholder equity is based on the idea that shareholder value should be based on what shareholders would receive if the company were sold or liquidated. Because liabilities and preferred shareholders are paid first, the true residual value is synonymous with shareholder equity.