As someone who has spent years analyzing financial markets, I find ordinary shares to be one of the most fundamental yet misunderstood instruments in corporate finance. Whether you’re an investor, a business owner, or a student of finance, grasping the mechanics of ordinary shares is crucial. In this article, I’ll break down what ordinary shares are, how they function, and why they matter in the broader economic landscape.
Table of Contents
What Are Ordinary Shares?
Ordinary shares, also known as common stock, represent ownership in a company. When I buy ordinary shares, I acquire a claim on the company’s assets and earnings proportional to my shareholding. Unlike preferred shares, ordinary shares typically come with voting rights, allowing me to influence corporate decisions such as electing the board of directors or approving mergers.
Key Characteristics of Ordinary Shares
- Voting Rights – Most ordinary shares grant one vote per share, though some companies issue dual-class shares with unequal voting power.
- Dividends – Dividends are not guaranteed. The board of directors decides whether to distribute profits, and ordinary shareholders are last in line after bondholders and preferred shareholders.
- Residual Claim – In case of liquidation, ordinary shareholders receive what’s left after creditors and preferred shareholders are paid.
- Capital Appreciation – The value of ordinary shares fluctuates based on market demand, company performance, and broader economic conditions.
How Ordinary Shares Work: A Mathematical Perspective
To understand the financial mechanics, let’s consider the valuation of ordinary shares. The most common method is the Dividend Discount Model (DDM), which estimates the present value of future dividends.
Dividend Discount Model (DDM)
The basic form of DDM assumes constant growth in dividends:
P_0 = \frac{D_1}{r - g}Where:
- P_0 = Current stock price
- D_1 = Expected dividend in the next period
- r = Required rate of return
- g = Growth rate of dividends
Example Calculation
Suppose Company XYZ pays an annual dividend of $2.00 per share, expected to grow at 5% annually. If my required rate of return is 10%, the intrinsic value of the stock is:
P_0 = \frac{2.00 \times (1 + 0.05)}{0.10 - 0.05} = \frac{2.10}{0.05} = \$42.00If the market price is below $42, I might consider the stock undervalued.
Importance of Ordinary Shares in the Economy
Ordinary shares play a pivotal role in capital markets. They allow companies to raise funds without taking on debt, and they provide investors with an opportunity to participate in corporate growth.
Comparison: Ordinary Shares vs. Preferred Shares
| Feature | Ordinary Shares | Preferred Shares |
|---|---|---|
| Voting Rights | Yes (usually) | No |
| Dividend Priority | Lower | Higher |
| Liquidation Claim | Residual | Senior to ordinary shares |
| Dividend Stability | Variable | Fixed or adjustable |
Why Investors Choose Ordinary Shares
- Growth Potential – Unlike bonds or preferred shares, ordinary shares offer unlimited upside if the company performs well.
- Inflation Hedge – Historically, equities have outpaced inflation over the long term.
- Ownership Influence – Voting rights allow shareholders to shape corporate governance.
Risks Associated with Ordinary Shares
While ordinary shares can be lucrative, they come with risks:
- Market Volatility – Share prices fluctuate due to economic, political, and company-specific factors.
- Dividend Uncertainty – Companies can cut or omit dividends during financial distress.
- Subordination in Bankruptcy – Ordinary shareholders recover funds last in liquidation.
Real-World Example: The Impact of Economic Cycles
During the 2008 financial crisis, many ordinary shareholders saw their investments plummet as banks and corporations faced insolvency. Lehman Brothers’ collapse wiped out ordinary shareholders entirely, highlighting the risk of residual claims.
Tax Implications of Ordinary Shares in the U.S.
In the U.S., ordinary shares are subject to capital gains tax. If I hold shares for over a year, I pay the long-term capital gains rate (0%–20%, depending on income). Short-term holdings (under a year) are taxed as ordinary income.
Example Tax Calculation
Assume I bought 100 shares at $50 each and sold them at $80 after 18 months. My capital gain is:
Gain = (80 - 50) \times 100 = \$3,000If my income bracket qualifies for a 15% long-term capital gains rate, my tax liability is:
Tax = 3,000 \times 0.15 = \$450How Companies Issue Ordinary Shares
When a company goes public via an Initial Public Offering (IPO), it issues ordinary shares to raise capital. Later, it may issue additional shares through secondary offerings, though this can dilute existing shareholders.
Dilution Example
If a company has 1 million shares outstanding and issues 200,000 new shares, my 10,000-share ownership drops from 1% to:
\frac{10,000}{1,200,000} \approx 0.83\%Conclusion
Ordinary shares are the backbone of equity investing, offering both opportunities and risks. Understanding their valuation, rights, and economic role helps me make informed investment decisions. Whether I’m a retail investor or a financial professional, grasping these concepts ensures I navigate the stock market with confidence.
