Preference shares also commonly known as preferred stock, is a special type of share where dividends are paid to shareholders prior to the issuance of common stock dividends. Ergo, preference share holders hold preferential rights over common shareholders when it comes to sharing profits. Consequently, if a company lands into bankruptcy, preference shareholders are issued dividends first or have the first right to the company’s assets before common stock investors. For preference shareholders, the dividend is fixed however, they don’t hold voting rights as opposed to common shareholders.
Investors who have been in the stock market for longer than most go after preference share types. The dividends earned on these shares are significantly higher than ordinary shares. Their popularity can be established by the fact that many preference shareholders do not own any other stock except for this variety.
It has been observed that more and more companies are coming out with different types of preference shares. In essence, they have traces of both equity and debt shares. From this angle, these shares are also categorised as hybrid financing instruments.
Over the last few years, as the bear market run continues globally, more investors are looking towards preference shares as a viable means of gaining significant returns in the long run.
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Several features have made these financial instruments the chosen vessels for investors. Most of these characteristics have made them superior earners even during low economic growth phases. The most attractive features are:
- Preference shareholders have significantly more heft than standard shareholders of any company. They have the first rights to all dividends paid by the companies whose shares they own.
- Holders of these shares do not have any voting rights in any business proceedings. The features, thus, also falls among the major disadvantages of preference shares. It might seem like a major handicap for any investor; however, it is precisely the reason why so many companies offer these shares. The aspect is also similar to debenture owners.
- One feature which is under-advertised is that the dividends are paid to the shareholders on specific dates. It is not entirely dissimilar to a monthly income.
- If an investor decides to buy a special type of these shares, they should look for irredeemable preference shares. These shares allow the holder to have a certain say on their maturity dates.
- One of the advantages of preference shares is that they are identical to PAT for most corporations. The taxation element is decided on the dividends that are payable on every pre-arranged dividend fund.
There are many types of preference shares prevalent in India ; enumerated below :-
- Cumulative Preference Share : Cumulative shares have a provision that allows investors to be paid dividends in arrears. It so happens that a company doesn’t have the financial capacity to pay dividends to its shareholders. Unless dividends are not paid to preference shareholders, they cannot be paid to common shareholders. In such a scenario, the company decides to pay cumulative dividends in the next year . Sometimes, interest earned by the shareholders on arrear dividends is also given to the cumulative preferred stock holders. 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 : Non cumulative preferred shareholders are eligible to be paid dividends only from a year’s profit. So a non cumulative preferred stock does not issue unpaid dividends to the shareholders neither can holders of such stock claim unpaid dividends in the future.
- Redeemable Preference Shares : In case of redeemable shares,a company has the right to buy back the shares for its own use from shareholders at a fixed date or by giving prior notice after a period of time.
- Irredeemable Preference Shares : These shares can only be redeemed by the company at the time of liquidation or when the company winds up operations.
- Participating preference shares : Participating preference shares is where the company issuing the dividends pays increased dividends to the shareholders along with the preference dividend. This is done at a fixed rate. Additionally, participating preference shareholders have rights on the surplus asset of the company at the time of its liquidation.
- Non Participating Preference Shares : In case of non participating preference shares the shareholders are entitled only to the dividends at a fixed rate and not to the surplus profit. The extra profit is distributed among the common shareholders.
- Convertible Preference Shares : Shareholders of such shares have the option to convert the common shares to preferred shared. These shares are opted by investors who wish to receive preferred share dividend as well as want to benefit from an increase in the common shares. So the benefits are two fold- fixed returns by means of preferred dividends as well as the opportunity to earn higher returns as the common stock price increases. This conversion can happen within a certain period as per prior agreement, stated in the memorandum.
- Non Convertible Preference Shares : Shareholders of these shares do not hold the rights to convert to issuer’s common shares.
- Preference shares with a callable option : For shareholders having preference shares with a callable option, the issuing company holds the right to call in or buy back the stocks at a predetermined price after a set date. The call price, date post which the shares can be called and the call premium are mentioned in the prospectus.
- Adjustable Rate Preference Shares : For such shareholders, the dividend rate depends on the prevailing interest rates in the market, and hence are not fixed.
Several reasons exist as to why these shares are preferred over other types. If you are an investor, opting for these shares is the way to future-proofing your investments, thus helping you reap the advantages of preference shares. For example, if by chance the corporation announces bankruptcy; all holders of preferential stocks will get the first and privileged access to the assets going under the hammer.
Such advantages are bound to attract those who have low-risk appetites when it comes to investments in uncertain times. Besides, if the company’s ordinary shares start performing extraordinarily well, the preferred shareholders can easily transfer some of the shares into standard ones and benefit therein.
One great feature which companies offer is callable preference shares. The nomenclature means that the investor has a right to repurchase the shares whenever he or she likes.
In short, there are several advantages which most investors can only benefit from.
Like all other financial instruments, these shares have certain inherent risks as well, highlighting the disadvantages of preference shares. During significant market fluctuations, there are doubts about how much dividends the shares will yield. Thus, those with slightly lower risk appetite may not prefer taking too many chances in this specific investment option.
Moreover, some types of preference shares which may initially guarantee greater returns as they are associated with PAT. However, the risks associated with the same may also be very high.
Lastly, these shares are issued primarily by companies that have a substantial market capitalisation and can provide substantial dividends to a very large subscriber base for a sustained period. It might seem a risk-mitigating factor but may or may succeed in the real world.
Investors who want assured dividends for a sustained period of time should consider preferred shares. The sheer variety and options that preference shares present encompassa a wide range of investors. If you are looking to invest in such shares , make sure you are aware of the pros and cons associated with them and ensure they align with your investment objectives and risk profile.