Definition of Ordinary Shares
A company issues ordinary shares to raise capital for the business. Ordinary shares also known as common shares are equity stock that provides a voting rights to the stockholders and the dividends are distributed on such shares as per management’s discretion based on 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.
Shareholders of ordinary shares can attend annual general meetings, and they are entitled to receive dividends as agreed by the management’s policy year on year. At the time of liquidation, ordinary shareholders receive their share of the remaining net assets. The market value of ordinary shares is determined by the market forces and investors’ sentiments.
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 right to receive dividends declared by the management.
- Ordinary share comes with 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 it back or delist it.
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 as well as preference share.
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%.
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Valuation of Ordinary Shares
There are three main methods for valuation of ordinary shares:
- Asset-Based Method: In an asset-based approach, the company’s net assets are divided by the number of ordinary shares outstanding to know the value of a single share. Net assets are calculated by deducting total external liabilities from total 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 of ordinary shares and the price earning capacity method (PEC) which uses historical earnings to calculate the value of the share.
- Market-Based Method: In this method, the market value of the shares is used for valuation purposes. The market value of the share is determined by market forces, type of business, and investors’ sentiments.
Ordinary Shares vs Preference Shares
The difference between ordinary shares and preference shares can be understood from the below table:
|
Ordinary Shares |
Preference Shares |
|
| Signifies proportionate ownership of shareholders in the company | Signifies preferential rights over the payment of dividend and repayment of capital at the time of liquidation | |
| Ordinary shares come with voting rights | Preference shares do not come with voting rights | |
| Dividends can be paid or not paid to ordinary shareholders as declared by the management. | Dividends will be paid at the fixed rate agreed at the time of the issue of the shares. | |
| At the time of liquidation, ordinary shareholders are repaid if anything is remaining after meeting all the liabilities. | At the time of liquidation, preference shareholders are paid before ordinary shareholders. | |
| Ordinary shares cannot be redeemed. | Preference shares come with a redemption clause at the end of a specified period of time. | |
| Ordinary share is generally non-convertible. | Some preference shares come with a clause of conversion to ordinary shares. |
Advantages
Some of the advantages are given below:
- It comes with the right to vote for the investors, i.e. shareholders can take part in managing the affairs of the company.
- Ordinary shares are an excellent source of finance and have no debt element in it.
- The listed ordinary shares can easily be traded in primary as well as the secondary market.
- 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. The number of shares can be increased through a new issue, the right issue, and can be reduced through a buy-back option.
Disadvantages
Some of the disadvantages are given below:
- Share prices of ordinary shares are mainly decided by the market forces which are volatile in nature and can lead to a lot of fluctuation in the value of the shares.
- If the company goes into bankruptcy shareholders can lose the entire investment amount.
- Dividends are never fixed or predefined. They are declared year on year as per the management decision. If the company decides to plough back the profits, there will be no dividends for the ordinary shareholders.
- Though ordinary shareholders have limited liability,at the time of liquidation, ordinary shareholders are paid last i.e. if anything is remaining after meeting all the liabilities.
Conclusion
Ordinary shares are one of the integral sources of finance. A company whether old or new highly relies on ordinary shares for raising finance. And their are lots of benefits attached to ordinary shares like such as voting rights, ownership, limited liability, and dividend rights.
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