Preference shares, commonly known as preferred stock, are a type of equity security issued by a company that combines characteristics of both common shares and fixed-income securities.
They offer a unique blend of features that appeal to certain types of investors. This article explores what preference shares are, their types, and the advantages and disadvantages associated with them.
What are Preference Shares
Preference shares are designed to offer investors a more stable and predictable return compared to common stock. They provide a fixed dividend that is paid out before any dividends are distributed to common stockholders. In the event of a company’s bankruptcy, preferred shareholders have a higher claim on the company’s assets than common shareholders, but they generally rank below bondholders and other debt holders.
While preference shares offer the benefit of prioritized dividends and asset claims, they usually come with trade-offs in terms of voting rights and potential capital gains. Unlike common shareholders, holders of preference shares typically do not have voting rights in company matters.
Types of Preference Shares
There are several types of preference shares, each with unique characteristics and benefits. The main types include:
1. Cumulative Preferred Stock
Cumulative preferred stock includes a provision that requires the company to pay all dividends, including any missed payments from previous periods, before any dividends can be issued to common shareholders. This type of stock ensures that shareholders receive any dividends that were omitted in the past, making it a more secure investment. Unpaid dividends are referred to as “dividends in arrears” and must be paid out to the current owner of the stock when they are eventually distributed.
Example Calculation:
- Quarterly Dividend = (Dividend Rate × Par Value) / 4
- Cumulative Dividends per Share = Quarterly Dividend × Number of Missed Payments
2. Non-Cumulative Preferred Stock
Non-cumulative preferred stock does not carry the same provisions as cumulative stock. If dividends are not paid in a given period, shareholders of non-cumulative preferred stock have no right to claim these missed dividends in the future. This type of stock is generally less expensive than cumulative preferred stock but offers less security for investors.
3. Participating Preferred Stock
Participating preferred stock allows shareholders to receive dividends based on the usual preferred rate plus an additional amount if the company’s common shareholders receive dividends above a certain level. In the event of liquidation, participating preferred shareholders may also receive back their original investment and a portion of any remaining proceeds distributed to common shareholders.
4. Convertible Preferred Stock
Convertible preferred stock gives shareholders the option to convert their preferred shares into a specified number of common shares, typically at a predetermined price. This feature allows investors to potentially benefit from increases in the value of the common stock. The conversion option adds an element of potential capital appreciation to the fixed-income nature of preferred shares.
Advantages of Preference Shares
1. Fixed Dividends
Preference shares often come with a fixed dividend, which provides investors with predictable income. These dividends are paid out before any dividends are given to common shareholders, offering a more stable return.
2. Higher Claim on Company Assets
In the event of bankruptcy, preferred shareholders have a higher claim on the company’s assets than common shareholders. This higher claim provides a layer of protection and increases the likelihood of recovering some value in a liquidation scenario.
3. Additional Investor Benefits
Some preferred shares are convertible, allowing investors to convert them into common shares under certain conditions. This can be advantageous if the common shares perform well. Additionally, participating preferred shares may offer extra dividends if the company meets specific performance targets.
Disadvantages of Preference Shares
1. Lack of Voting Rights
Preferred shareholders typically do not have voting rights, which means they cannot influence company decisions. This is a significant drawback compared to common shareholders who do have voting rights.
2. Interest Rate Sensitivity
The fixed dividend on preference shares can become less attractive if interest rates rise. If market interest rates increase, the fixed dividend on preference shares may seem less appealing compared to other investments with higher yields, potentially leading to buyer’s remorse.
3. Potential for Limited Upside
While preferred shares provide stability and fixed income, they generally do not offer the same potential for capital appreciation as common shares. This means that while investors can expect consistent returns, they may miss out on significant price increases of common stock.
Conclusion
Preference shares offer a unique investment opportunity that blends the features of both common stock and fixed-income securities. They provide prioritized dividends and a higher claim on assets but come with limitations such as the lack of voting rights and potential sensitivity to interest rate changes. Understanding the different types of preference shares and their associated advantages and disadvantages can help investors make informed decisions based on their financial goals and risk tolerance.
Whether you are a risk-averse investor seeking stable income or someone interested in potential capital appreciation, preference shares can be a valuable addition to a diversified investment portfolio.
FAQs
What Are Preference Shares?
Preference shares are a type of stock with fixed dividends that are paid out before common stock dividends. They also have a higher claim on assets if the company goes bankrupt.
How Do Preference Shares Perform in Bankruptcy?
Preference shareholders are paid before common shareholders but after debt holders.
Can Preference Shares Be Converted?
Yes, convertible preference shares can be converted into common shares.
Are Preference Shares a Good Investment?
They are suitable for those seeking stable income and a higher claim on assets but may not be ideal for those seeking high capital growth.
How Do Cumulative and Non-Cumulative Preferred Shares Differ?
Cumulative shares accumulate unpaid dividends, while non-cumulative shares do not.
