American depositary shares (ADS) come into play when a foreign company wants its shares to trade on a major American exchange as U.S. dollar-denominated equity. Securities laws prevent foreign corporations that have shares trading in a foreign market to directly list their shares on U.S. stock exchanges (exceptions do occur, such as for Canadian companies).
How ADS and ADR Relate to Common Stock
Foreign companies are forced to create ADS as a result of these laws. These shares represent the full rights of the common stock they are based on. ADS are then securely held by a bank or financial institution in the foreign company's country, at which point American depositary receipts (ADR) are created to represent the ADS for listing on the desired American exchange.
ADRs are typically the units investors buy and sell on U.S. exchanges. ADRs represent the ADS units held by the custodian bank in the foreign company's home country. ADRs can be issued against ADS at any ratio the company chooses.
For example, ABCWXYZ company could have ADR trading on the New York Stock Exchange (NYSE). These ADRs could be issued at a rate of five ADRs equal to one American Depository Share (5:1), or any other ratio the company chooses.
However, the underlying ADS most often corresponds directly to the foreign company's common shares. In other words, the ratio of ADS to common shares is usually one, while the ratio of ADR to ADS can be whatever a company decides to issue them at. Sometimes firms can issue ADS to represent more than one common share each, but usually the ratio is one-to-one.
Foreign companies that offer shares on U.S. exchanges as ADS gain the advantage of a wider investor base, which may lower costs of future capital.