Skip to main content
← Back to P Definitions

Potential ordinary shares

What Are Potential Ordinary Shares?

Potential ordinary shares are financial instruments or other contracts that may entitle their holder to receive common stock in a company. These shares are not currently outstanding as regular equity but have the possibility of converting into, or being exercised for, ordinary shares in the future. Their existence is a critical consideration in corporate finance and equity analysis because they can impact a company's per-share metrics, notably earnings per share (EPS), through a process known as dilution. Examples include convertible securities (such as convertible bonds or convertible preferred stock), stock options, warrants, and certain types of employee stock ownership plans (ESOPs).

History and Origin

The concept of potential ordinary shares evolved with the increasing complexity of corporate capital structure and the need for more nuanced financial reporting. While simple forms of convertible debt have existed for centuries, their widespread use and the formal accounting treatment of their potential impact on shareholder metrics became prominent in the 20th century. The introduction of employee stock options as a form of compensation, particularly from the mid-20th century onward, significantly increased the volume and types of instruments that could lead to future share issuance. Accounting standards bodies, such as the Financial Accounting Standards Board (FASB) in the United States and the International Accounting Standards Board (IASB) globally, developed specific rules to address how these instruments affect reported earnings per share, ensuring transparency for investors.

Key Takeaways

  • Potential ordinary shares are financial instruments that could convert into common stock, increasing the number of outstanding shares.
  • They include items like convertible bonds, convertible preferred stock, stock options, and warrants.
  • Their primary significance lies in their potential to dilute existing shareholders' ownership and earnings per share.
  • Companies must account for potential ordinary shares when calculating diluted earnings per share, which is a key financial metric.
  • Ignoring potential ordinary shares can lead to an overstatement of per-share metrics and misrepresent a company's true financial performance.

Interpreting Potential Ordinary Shares

Understanding potential ordinary shares is crucial for accurately assessing a company's financial health and shareholder value. When these instruments are converted or exercised, they increase the total number of shareholders and outstanding shares, which can reduce the per-share value of earnings and ownership for existing investors. This effect is known as dilution. Analysts and investors closely scrutinize a company's potential ordinary shares, especially when evaluating its earnings per share (EPS) figures. A higher number of potential ordinary shares, relative to current outstanding shares, suggests a greater risk of future dilution. Conversely, if a company has few or no potential ordinary shares, its current EPS may be more stable and less susceptible to future downward adjustments from new share issuance.

Hypothetical Example

Consider "TechGrowth Inc.," a hypothetical public company with 10 million common stock shares currently outstanding. In addition, TechGrowth Inc. has issued:

  • Convertible Bonds: $10 million in convertible bonds, with each $1,000 bond convertible into 50 shares of common stock. (This equates to 10,000 bonds * 50 shares/bond = 500,000 potential ordinary shares).
  • Employee Stock Options: 1 million outstanding employee stock options with an average exercise price significantly below the current market price.

If all these potential ordinary shares were to convert or be exercised, TechGrowth Inc. would have 10 million (current) + 0.5 million (convertible bonds) + 1 million (stock options) = 11.5 million shares outstanding. This significant increase from 10 million to 11.5 million shares represents a potential dilution of 15%. This calculation illustrates how potential ordinary shares represent a future claim on a company's equity that can materially alter per-share metrics.

Practical Applications

Potential ordinary shares play a significant role in several areas of finance, primarily in financial statements and valuation. Companies issuing these instruments often do so to raise capital, manage their debt obligations, or incentivize employees. For example, convertible securities allow companies to issue debt at lower interest rates, with investors accepting the trade-off for potential equity participation. Similarly, stock options are a popular form of non-cash compensation, aligning employee incentives with shareholder value.

Regulators mandate that companies disclose the potential dilutive impact of these shares. In the United States, the Securities and Exchange Commission (SEC) requires public companies to report diluted earnings per share, which accounts for the potential conversion or exercise of these instruments. The SEC's Staff Accounting Bulletin Topic 4 provides interpretive guidance on earnings per share computations for public offerings, which includes the treatment of potentially dilutive instruments.5 Globally, International Accounting Standard (IAS) 33, "Earnings Per Share," similarly guides companies on how to calculate and present both basic and diluted EPS, explicitly defining "potential ordinary shares" and the conditions under which they are considered dilutive.3, 4 The volume of such issuances can be substantial; for instance, global convertible bond issuance has seen significant surges in recent years, with 2021 experiencing record levels.2

Limitations and Criticisms

The primary limitation and criticism surrounding potential ordinary shares revolve around their dilutive effect on existing shareholders and the complexity they add to financial analysis. While these instruments offer companies flexibility in raising capital or compensating employees, the subsequent dilution can reduce the value of each existing share and dilute future net income per share. This can be particularly problematic if a company issues a large number of stock options at low exercise prices, potentially leading to substantial dilution when those options become "in the money" and are exercised.

Furthermore, the accounting for potential ordinary shares, especially for calculating diluted EPS, can be complex, involving assumptions about exercise and conversion that may not fully materialize or might be subject to antidilution provisions. Critics argue that overly complex accounting treatments can obscure the true economic impact of these instruments. The Federal Reserve Bank of San Francisco has noted the complexity and debate surrounding the accounting for stock options, highlighting how different methodologies can significantly impact reported earnings.1 Misinterpretation of the potential impact of these shares can lead investors to misjudge a company's true financial performance and future prospects.

Potential Ordinary Shares vs. Diluted Shares

While closely related, "potential ordinary shares" and "diluted shares" refer to different aspects of a company's equity structure.

Potential ordinary shares are the types of financial instruments that, if converted or exercised, would increase the number of outstanding common shares. They are the instruments themselves, such as convertible bonds, stock options, and warrants.

Diluted shares (or "fully diluted shares") refer to the hypothetical total number of common shares that would be outstanding if all potential ordinary shares were converted or exercised. This number is used as the denominator in the calculation of diluted earnings per share (EPS). It represents the most conservative estimate of outstanding shares, assuming maximum possible dilution from existing instruments.

In essence, potential ordinary shares are the source of dilution, while diluted shares are the result of considering that potential dilution. A company reports its basic shares outstanding (actual shares currently held by investors) and its diluted shares outstanding (basic shares plus the impact of all dilutive potential ordinary shares).

FAQs

What is the primary purpose of potential ordinary shares for a company?

Companies issue potential ordinary shares primarily to raise capital or to provide incentives to employees and executives without immediately issuing new common stock. This allows them to obtain financing or talent under terms that might be more favorable than direct equity issuance or cash compensation. For instance, convertible debt typically carries a lower interest rate than non-convertible debt because of the embedded option to convert into equity.

How do potential ordinary shares affect earnings per share (EPS)?

Potential ordinary shares affect earnings per share by increasing the number of shares in the denominator of the EPS calculation. When calculating "diluted EPS," the shares represented by these instruments are added to the existing outstanding shares, leading to a higher share count. This higher share count, assuming net income remains constant, results in a lower reported diluted EPS compared to basic EPS, reflecting the maximum potential dilution.

Are potential ordinary shares always converted or exercised?

No, potential ordinary shares are not always converted or exercised. Their conversion or exercise often depends on certain conditions, such as the market price of the underlying common stock exceeding the exercise price for options or warrants, or a strategic decision by the holder of convertible bonds. If conditions are unfavorable (e.g., the stock price is below the exercise price), the instruments may expire unexercised or remain as debt.

How do analysts assess the impact of potential ordinary shares?

Analysts assess the impact of potential ordinary shares by calculating diluted earnings per share (EPS), which provides a more conservative view of a company's profitability per share. They also examine the terms of these instruments, such as exercise prices and conversion ratios, and consider the likelihood of their conversion based on current market conditions and the company's prospects. This helps them understand the full scope of potential dilution and its effect on shareholder value.