Updated July 19, 2023
Definition of Ordinary Shares
A company issues ordinary shares to raise capital for the business. Ordinary shares, also referred to as common shares, are a type of equity stock that grants voting rights to shareholders.
The distribution of dividends on ordinary shares is at the discretion of the management, contingent upon the availability of profits. These shares represent ownership of stockholders in the company in proportion to their shareholding in the company.
Explanation
It provides ownership to the investors in the company proportionate to the number of shares owned by them. It is an excellent source of raising finance as it does not have a debt element in it. As the owner of the company, ordinary shareholders have some rights, such as voting rights. At the time of liquidation, ordinary shareholders receive their share of the remaining net assets.
Characteristics of Ordinary Shares
- It comes in conjunction with voting right i.e. any investor who invests in ordinary shares of the company will have proportionate ownership in the company.
- Ordinary share gives the investor the right to receive dividends declared by the management.
- Ordinary share comes with a limited liability component i.e. at the time of the liquidation, each shareholder will be liable to the company up to the extent of the unpaid share capital held by them.
- Ordinary shares have no specific maturity date unless the company buys them back or delists them.
Example of Ordinary Shares
For example, let us suppose a company has issued 10,000 ordinary shares and 5,000 preference shares for $2 per share for both ordinary and preference shares.
Now ordinary share capital of the company would be (10,000 x $20) = $200,000
And suppose an investor has 1,000 ordinary shares. Therefore, the percentage of ownership held by the shareholder is (1000÷10,000 x100) i.e. 10%.
Valuation of Ordinary Shares
- Asset-Based Method: To determine the value of a single share in an asset-based method, the company’s net assets are divided by the number of ordinary shares outstanding. Total external liabilities are subtracted from total assets to calculate net assets. This method is mainly popular with manufacturers, distributors, or capital-intensive companies.
- Income-Based Method: Income-based method is further classified into the discounted cash flow (DCF)method, which uses the discounted value of projected cash flow to determine the fair value and the price earning capacity method (PEC), which uses historical earnings to calculate the value of the share.
- Market-Based Method: This method utilizes the market value of shares for valuation purposes. The market value is determined by factors such as market forces, the type of business, and investors’ sentiments.
Ordinary Shares vs Preference Shares
|
Ordinary Shares |
Preference Shares |
|
| Signifies proportionate ownership of shareholders in the company | Signifies preferential rights over the payment of dividends and repayment of capital at the time of liquidation | |
| It comes with voting rights. | Preference shares do not come with voting rights. | |
| Dividends can be paid or not paid to ordinary shareholders, as the management declares. | Dividends will be paid at the agreed-upon fixed rate specified during the issuance of the shares. | |
| At the time of liquidation, ordinary shareholders are repaid if anything remains after meeting all the liabilities. | Throughout the liquidation process, preference shareholders are compensated before ordinary stockholders. | |
| It cannot be redeemed. | Preference shares come with a redemption clause at the end of a specified period of time. | |
| An ordinary share is generally non-convertible. | Some preference shares come with a clause of conversion. |
Advantages
- It comes with the right to vote for the investors, i.e. shareholders can take part in managing the affairs of the company.
- They are an excellent source of finance and have no debt element in them.
- It gives investors the benefit of capital gains and dividends.
- The companies have a lot of flexibility in regard to how many shares it wants to keep floating in the market. A new issue or a rights issue can raise the number of shares, whereas a buyback option can decrease the number of shares.
Disadvantages
- Market forces, which are volatile in nature, primarily determine share prices and can cause significant fluctuations in their value.
- If the company goes bankrupt, shareholders can lose the entire investment amount.
- If the company decides to plow back the profits, there will be no dividends for the ordinary shareholders.
Conclusion
They are one of the integral sources of finance. A company, whether old or new, highly relies on ordinary shares for raising finance. It has a lot of benefits attached to them, including voting rights, ownership, limited liability, and dividend rights.
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