What Preference Shares Mean & Different Types of Preferential Stocks
When we talk of investing in shares, equity shares immediately come to mind. However, other than equity shares, preference shares are another popular type.
Preference shares, also known as preferred shares or simply “prefs”, are a type of equity security that combines elements of both debt and equity. These securities possess characteristics of both common stocks and bonds, making them hybrids. In this blog, we will explore everything you need to know about equity and preference shares, including preference share definition, types, features, advantages, disadvantages, and examples that may help you understand this type of equity security and make informed investment decisions.
What is Preference Share?
Preference shares are a type of share capital issued by a company to investors, providing them with a preferential claim to the company’s earnings and assets. Thus, a company’s preference share capital comes from issuing preference shares.
Furthermore, a preference share with a right to a profit share is known as a participating preference share. The primary feature is that they receive a fixed dividend paid out before common shareholders receive any dividends. In case of a liquidation, preference shareholders have priority over common shareholders in receiving their share of the company’s assets.
Now let’s discuss the preference share types in the next section.
What are the Different Types of Preference Shares?
There are several type of shares that companies can issue. Hence, the most common types are:
- Cumulative Preference Shares: These shares are entitled to receive any unpaid dividends from previous years. Before common shareholders receive any dividends. This means that if the company cannot pay dividends in one year, the unpaid dividends accumulate and are paid out in the following years.
The calculation is as follows –
- Quarterly Dividend = [Rate of dividend * Par Value ] divided by 4
- Cumulative dividends paid per share = Quarterly dividend * Total Number of payments missed
- Non-Cumulative Preference Shares: If the company cannot pay dividends in a given year, the shareholders do not have the right to accumulate dividends for future years.
- Convertible Preference Shares: These can be converted into common shares at a predetermined price and time. This allows investors to benefit from potential capital appreciation in the future.
- Non Convertible Preference Shares: Usually cannot be converted into equity shares. Non-convertible preference shares lack this conversion feature.
- Participating Preference Shares: Participating preference shares can provide shareholders with the right to receive both a fixed dividend and an additional share in the company’s profits. In the event of surplus profits after the payment of the fixed dividend.
- Non-Participating Preference Shares: Non-participating preference shares can only entitle shareholders to a fixed dividend. They do not participate in any additional profits. These are predetermined to dividends and are considered conservative investments.
- Redeemable Preference Shares: The company’s preference shares can be redeemed at a predetermined price and time. These redeemable shares provide the company with flexibility in managing its capital structure.
- Non-Redeemable Preference Shares: Also known as irredeemable preference shares that may not have a fixed maturity date for redemption. Unlike redeemable, which can be bought back by the company after a specified period, non-redeemable remains outstanding indefinitely.
What are the Features of Preference Shares?
Preference shares have several distinctive features that differentiate them from other types of shares. Some of the characteristics of preference shares:
- Preference in Payment of Dividends: Preference shareholders are the ones who can be entitled to receive dividends at a fixed rate. Before any dividends are paid to common shareholders. This means that they receive priority in the distribution of earnings.
- Preference in the Distribution of Assets: In case of a liquidation, preference shareholders have priority over common shareholders.
- No Voting Rights: Unlike common shareholders, preference shareholders typically do not have voting rights. They have limited say in the management and decision-making of the company.
- Fixed Dividend Rate: The dividend rate for preference shares is usually fixed and does not change over time. This provides investors with a stable source of income.
- Limited Liability: Like common shareholders, preference shareholders get to have limited liability. This means they are not personally liable for the company’s debts and obligations beyond their investment.
Factors to Consider Before Investing in Preference Shares
Let’s have a look at the factors you might consider before investing in preference stocks.
- Dividend payment: Usually offers a fixed dividend, which can provide a steady stream of income for investors. However, the dividend payment cannot be guaranteed. Thus, the company may decide to suspend or reduce if it is experiencing financial difficulties.
- Conversion Rights: The conversion price is usually set at a premium to the current market price. So the conversion option may not be valuable if the stock price does not surpass the conversion price.
- Callable Feature: Some are callable, meaning the company can redeem them at a specified price. This can be a disadvantage for investors, as it allows the company to force them to sell their shares.
- Credit Rating: A higher credit rating suggests greater financial stability and a higher probability of meeting obligations.
- Liquidity: It is advisable to be aware that the lower liquidity may affect their ability to trade preference shares promptly.
- Investment Goals: Investors may consider their investment goals before choosing preference shares. However, investors seeking capital appreciation might find common shares more suitable.
- Risk Tolerance: It is advisable to assess risk tolerance. Recognizing that preference shares might be less risky than common shares, still carry market risks.
- Seek professional advice: Investors may seek professional advice from financial advisors to evaluate their risk tolerance and investment goals.
How to Buy Preference Shares?
If you are interested in redeeming preferred shares, buying them can be similar to buying common shares, and can be done through a variety of channels. These include brokerage firms, online trading platforms, and financial advisors. Here is an example of how you can buy them through a brokerage firm:
- Choose a brokerage firm: Research and choose a reputable brokerage firm that offers preference shares trading.
- Open an account: Open a demat account with the desired brokerage firm, providing the necessary personal information and funding the account with the desired amount.
- Research: Research and evaluate different preference shares types and companies that offer them, including their financial performance, dividend history, and credit rating.
- Place an order: Once you have decided, you can place an order through your brokerage firm. You can specify the quantity, price, and any other conditions for your order.
- Monitor your investment: Keep track of your investment through your brokerage account or by regularly checking the company’s financial reports and news.
Example
If you’re interested in buying large corporation shares then research and compare the various types of preference shares they offer. Then, you would open a trading account with a brokerage firm that allows you to buy the company’s shares. The next step is to place an order at your brokerage firm and monitor your investment as the market fluctuates.
Therefore, invest wisely and monitor your investment, to reap the benefits of a stable source of income.
What are the Preference Shares Advantages?
Preference shares advantages and disadvantages to both investors and companies. Hence, some of the key advantages are:
- Stable Source of Income for Investors: Preference shareholders receive a fixed dividend rate, which provides them with a stable source of income. This is especially attractive to investors who are looking for steady returns.
- Lower Financial Risk for the Company: These may not carry voting rights. Thus, the company can raise capital without diluting ownership or control. Additionally, preference shares do not require the same level of financial disclosure as debt financing.
- No Dilution of Ownership: Unlike common shares, preference shares do not dilute the ownership of existing shareholders. This means that existing shareholders can maintain their percentage of ownership in the company.
Are There Any Disadvantages?
However, it’s important to note that every investment carries some risk. One such risk is the fixed dividend obligation, which can put pressure on the company during periods of financial distress. Additionally, the shares typically offer limited potential for capital appreciation, which may not be suitable for investors seeking long-term growth.
In addition, certain types of preference stocks that are associated with PAT may initially guarantee greater returns. The same may, however, also come with a high level of risk.
Furthermore, investing in types of shares can help diversify your portfolio. Additionally, it provides a steady stream of income for those looking to maintain financial stability. Lastly, preference shares might seem a risk-mitigating factor but may or may succeed in the real world.
However, it is advisable to understand the risks or disadvantages of preference stocks and consult your financial advisor to make a sound decision.
Preference Shares Example
Let’s consider that Reliance Industries Limited is issuing a 7% preferred share at 80,000 Rs par value. As a result, the investor would receive a Rs. 5600 annual dividend. Typically, this preferred share will revolve around its par value behaving much more similar to a bond. Thus, investing in preferred shares can be a great way to diversify your portfolio and reap the rewards of a steady income stream. Additionally, preferential stock is most commonly issued by the financial sector to raise capital.
Preferred Share vs Common Share vs Dividend Share
Preferred stock, common share, and dividend share are the three types of securities that represent ownership in a company but differ in their characteristics and benefits. Some of the differences are listed below.
| Factor | Preferred Shares | Common Shares | Dividend Shares |
|---|---|---|---|
| Definitions | Ownership in a company with preferential treatment in dividend distributions and potential claims in the event of bankruptcy or liquidation. | Represents ownership in a company with no preferential treatment in dividend distributions and potential claims in the event of bankruptcy or liquidation. | Represents a portion of a company’s profits paid out to shareholders as a return on their investment. |
| Voting Rights | Limited or no voting rights | One vote per share | No voting rights |
| Priority in Distributions | Prioritized in the distribution of assets. | Paid after creditors and preferred shareholders. | No priority in dividend distributions |
| Risk and Reward | Lower potential for capital appreciation but less volatility | Higher potential for capital appreciation but higher volatility | No ownership in the company, but receive a portion of profits in the form of dividends. |
| Convertibility | Some preferred shares are convertible to common shares | Cannot be converted to preferred shares | Not convertible |
To Wrap It Up…
If you are one of those investors interested in generating consistent cash flow from their equity holdings, then equity shares and preference shares can be a good investment option for you. These preference shares and its types can be popular financial instrument that may offer company ownership. Also gives you prioritized treatment during dividend distributions.
However, it is advisable to consider the cost of these shares. As they typically come with a higher dividend payout compared to common equity shares. And thus, can be considered as one of the preferred investment tools for many investors.
FAQs
Equity shares are known as ownership or common shares. They represent ownership in a company, granting shareholders voting rights and a share in profits through dividends.
Preference shares meaning shares of a company, represent ownership with preferential rights. These preference share holders receive fixed dividends before common shareholders and often have priority in the event of liquidation.
Preference shareholders are called investors who hold a special class of shares in a company. They receive fixed dividends before common shareholders and have priority in case of liquidation.
The types of preference share capital include participating in non-participating, non-redeemable and non-convertible, each with distinct features and characteristics.
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