When you go into a store, it’s possible for an individual or group of individuals to “buy out” a certain store’s “stock” of an item. However, you realize that when you do that you’re not really buying these items out of existence. The company will manufacture more. Marketing is based on this simple concept. When the demand for that item outweighs the supply of that item, the price will increase. That’s why parents rush to buy whatever the “hot toy” is for Christmas. Subsequently, if an item lingers on the shelves, the company will have to lower the price, or the store will decrease its shelf space, in an effort to stimulate demand.
This simple illustration in our personal shopping habits illustrates an important similarity and difference between owning and investing. As a shopper, you are seeking to own items that can potentially be infinite. Will a store ever really run out of Oreo cookies or Charmin toilet paper? Maybe temporarily, but not for long. However, owning a stock is a different situation.
A share of stock represents a piece of ownership in a company. But unlike Oreo cookies or Charmin toilet paper, they are, in theory, finite commodities. Companies have to report to a board of directors that determine how many shares of a company will actually be available to investors.
With that in mind, investors may wonder, “If I’m buying pieces of a company, will a business ever run out of shares to sell? Could a business ever lose controlling interest of their company because of all the shares that have been purchased?”
To understand the answer to both questions, you need to understand that not all shares are equal. The topic of this article is outstanding shares. We’ll explain the definition of outstanding shares, how they are different from other kinds of shares, how company’s report the number of outstanding shares, how the number of outstanding shares can increase or decrease, and why they are important.
What are outstanding shares?
Outstanding shares are the number of shares of stock that a company has issued and can be bought and sold by public and institutional investors. These are sometimes referred to as shares in float and are different from the number of authorized shares a company may issue.
Outstanding shares are the shares that you and I purchase through a brokerage or directly from the company. These can also be called “publicly traded shares”. Although that definition is only partially correct.
How are outstanding shares different from authorized shares?
Authorized shares are the maximum number of shares a company can issue. This number, which is established in the company’s articles of incorporation when the company is formed, can only be adjusted up or down by the vote of shareholders. Remember, as a shareholder you are a part owner of this company, and ownership comes with responsibilities. Typically, companies vote on whether to increase the number of outstanding shares they issue at their annual shareholder meeting. You will receive a notice of this meeting and should review it carefully to see what will be on the agenda. In many cases, the notice will allow you to send in your vote. You don’t have to actually attend the meeting, but if you do not express your opinion, the company will vote for you “by proxy” and will usually assume that your vote is in line with their intentions.
Authorized shares are broken down into three basic categories: treasury stock, restricted shares, and outstanding shares. Here's a brief breakdown of these categories:
Treasury stock: Stock that is held by the company itself
Restricted shares: Registered shares of stock that are issued to executives and directors of a company, as well as other affiliates. These shares are typically regarded as a form of employee compensation and are available to the recipient after a designated “vested” period. Recipients of restricted shares cannot transfer their stock and can only trade the shares in compliance with special Securities and Exchange Commission (SEC) regulations.
Outstanding shares: The number of authorized shares that are available to be bought and sold by the public. This number includes restricted shares but does not include treasury stock.
To illustrate this, let’s say a company authorizes 1,000 shares of stock to be issued. However, they designated 300 shares as treasury stock and 100 shares as restricted shares. The number of outstanding shares would be:
1,000 shares – 300 shares (treasury stock) = 700 outstanding shares
How can you know how many shares are outstanding?
Every publicly traded company must report the number of outstanding shares on their balance sheet. This information should also be readily available through their investor relations, which is typically accessible through their website. This information will also be displayed on financial news websites where stock quotes are displayed. Additionally, a company must report the number of outstanding shares they have in their quarterly filings with the Securities and Exchange Commission (SEC).
How does a company increase their number of outstanding shares?
A company can increase the number of outstanding shares in three common ways:
- Equity financing – This is where a company issues outstanding shares as a way of raising capital by making their stock available to public or private investors. For example, a previously private company, particularly a start-up, that is in the early stages of growth may require additional capital but lacks the revenues, cash flow or hard assets that can provide collateral. In this case, companies usually approach venture capitalists or angel investors asking them to help assume the risk. In this case, the investor or investors who agree to provide financing usually take ownership (although not controlling interest) in the company. The goal in this situation is for the company to eventually buy out the investor as their earnings and profit increases.
For example, a couple may invest $500,000 of their own money when they start a business. In order to raise capital, they will offer an investor an ownership stake for their investment. The shares are typically sold for $1 share. If the investor puts up $250,000, they now own 33% of the company.
Established companies that have cash flow and assets can also raise money through equity financing. These are usually done by making public offerings of their stock to the stock and/or bond markets.
- Employees exercise stock options – Employee stock options are part of a company’s restricted stock options, but once the shares are sold, they will typically become available on capital markets.
- Companies issue stock splits – Stock splits are a way that companies can increase liquidity in their existing stock, and to allow their stock price to be more accessible to public investors. When a stock splits, shareholders will see an immediate increase in the number of outstanding shares they own by whatever the multiple of the split is. However, the total value of their investment will stay the same. So if an investor owns 100 shares of a stock that are priced at $50 a share, their investment is worth $50,000. If the company issues a two-for-one stock split, they will now own 200 shares, but the stock price will now be $25 per share, leaving their investment value unchanged at $5,000.
These are usually done as two-for-one or three-for-one splits, but it can be much higher. For example, many years ago when Apple's stock was in excess of $700 per share, the company issued a seven-to-one split.
How does a company decrease their number of outstanding shares?
A company can decrease their number of outstanding shares in two ways:
- Stock buyback – in this case, a company will purchase shares of their stock that are being publicly traded. When this happens, the shares either have to be canceled or turned into treasury stock. In either case, by pulling shares off the market, the price per share will, at least temporarily, increase. This can be seen as a positive sign if the management and investors correctly feel the stock price was undervalued. However, some companies will do this as a way to make their performance look better than it really was, which can be a sign that the company is not doing well.
- Reverse stock split – this is not as common and should be a little more concerning for investors. In this case, if a shareholder used to own 200 shares they will now own 100 shares. However, the value of their shares will increase. In reality, when a company engages in a reverse stock split, it usually puts the stock under additional selling pressure.
Why is it valuable to understand outstanding shares?
Outstanding shares provide one key metric in analyzing a company’s performance. That’s because knowing the number of outstanding shares makes it possible to calculate important financial metrics such as a company’s market cap and their earnings per share.
As an investor, you’ll also notice that companies can display their number of outstanding shares in two different ways. The most common way is to list the basic number of outstanding shares, which is simply the current number of outstanding shares. The second way is called the fully diluted number. Fully diluted shares include the number of outstanding shares that are currently being issued as well as shares that can be claimed either because preferred stock is being converted or investors will exercise stock options or warrants. In this way, the fully diluted number takes into account how many outstanding shares there could potentially be.
Knowing the number of fully diluted shares gives an investor a sense of their “fully diluted” ownership percentage, which can be more meaningful since the fully diluted number includes the number of potential common shares.
The bottom line on outstanding shares
Understanding outstanding shares is one of the building blocks of your investment education. Just as understanding addition and subtraction gives you the building blocks to understand multiplication and division. This easy-to-understand metric is a key building block to understanding the true valuation of a company.
In this article, we’ve explained why a healthy company may want to increase their outstanding shares either to help finance necessary growth or to increase liquidity in their stock and to make their stock price more attainable which can further increase the overall value of their stock.
We’ve also explained why it’s typically not a good sign when a company chooses to decrease the number of shares they have outstanding.
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