The stock market offers numerous exciting opportunities with distinct risk and reward ratios. Preference shares stand out in the investing landscape as an appealing option for seasoned investors and novices seeking consistent returns against a lower risk comparatively in the stock market.
They can enjoy a strategic presence in a firm. A range of preference shares are available for investors with varied risk profiles and financial objectives.
In this article, let’s understand preference shares, their characteristics, pros and cons, and how market forces impact them.
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What are preference shares?
Preference shares are a type of equity representing a unique class of ownership in a company. As the name suggests, they are issued with a few privileges for investors.
Preference shareholders are entitled to receive the dividends announced by the company before common shareholders. Here are some of the unique characteristics of preference shares that can help to understand preference shares’ meaning with more clarity:
- Hybrid investment
Preferential issues are called hybrid investments as they offer fixed dividend payments like debt securities and carry ownership characteristics, bringing them close to equity investments.
- Fixed dividend rate
Preference shares offer a predetermined dividend rate, which adds consistency to investment portfolios in contrast to common shareholders, whose distributions may change depending on the company’s financial success.
- Liquidation preference
If a company winds up, preference shareholders are on the priority list over common shareholders in the asset distribution among creditors. This feature of preference shares safeguards investors’ allocated funds.
- Restricted or no voting rights
In exchange for their preferential treatment in dividend payments and during liquidation, investors have to give up their voting rights.
Types of preference shares
Following are the types of preferences shares, based on varied aspects:
- Based on dividends
Preference stocks can be cumulative or non-cumulative shares. If the company has not paid dividends in a particular period, cumulative preference stocks accumulate those unpaid dividends.
These unpaid dividends are settled before dividend distribution to common shareholders. While cumulative preference shares accumulate unpaid dividends over time, non-cumulative ones do not.
- Based on redeemability
Some preference shares are issued with the flexibility of buyback. Companies can buy back their callable or redeemable preference shares from shareholders. Companies adjust their capital structure as required with the buyback of shares.
- Based on convertibility
There can be convertible and non-convertible preference shares. Convertible preference stocks offer shareholders the option to be converted into common shares.
They receive a predetermined number of common shares, providing an opportunity for future capital appreciation.
- Based on participation
Non-participating preference stocks receive a fixed-rate dividend. On the other hand, participating preference stocks give shareholders the right to receive additional dividends besides their fixed rate.
Reasons behind issuing preference shares
There are different ways to raise capital in the market. But many companies consider issuing preferred shares due to the following key reasons:
- Controlled debt-to-equity ratio: Issuing preference shares is one of the preferred ways for companies to raise fresh capital while limiting their debt-to-equity ratio. Companies want to show reduced debt on their balance sheets as it indicates high credibility to shareholders and analysts.
- A higher degree of control over corporate decisions: Companies often opt to issue preference shares as a strategic means to maintain a high degree of control over business and voting rights to vital corporate decisions. It safeguards the company’s strategic vision.
- Avoiding profit distribution: When companies issue common shares, they need to pay dividends according to their performance. Exceptional company performance can lead to higher dividend payments. On the other hand, generally, preference shareholders receive dividends at a fixed rate.
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Differentiating between preference and common shares
Common (equity) shares and preference shares offer distinct types of ownership in a business as defined below:
- Rights: Common shares typically grant voting rights to shareholders to participate in key decisions. They can vote while selecting the company’s board of directors, unlike preference shares.
- Earnings: Dividends to common shareholders may vary based on the availability of the company’s profits. Conversely, preference shareholders are entitled to receive dividends at a predetermined fixed rate.
- Risk: Common shareholders need a higher risk tolerance than preference shareholders.
- Residual claims: In an unfortunate event of liquidation, common shareholders can claim the company’s assets only after payments to creditors and preference shareholders.
Here is a simple table highlighting the differences between common and preference shares:
|Area of difference||Common (Equity) shares||Preference shares|
|Voting rights||Full voting rights||Limited or no voting rights|
|Dividend structure||Dividends may vary based on profits||Fixed dividend rate|
|Risk and return||Higher risk, higher potential returns||Lower risk, stable returns|
|Investors’ focus||Focus on capital appreciation||Focus on consistent income|
Market for preference shares
You may wonder how to buy preference shares. Preference shares, like equity shares, are listed and traded on stock exchanges. Preference Shares can be acquired through an initial public offering (IPO), follow-on public offering (FPO) in the primary market or on stock exchanges in the secondary market, depending on their listing status.
The way investors trade equity shares, investors can trade preferential issues also using a brokerage account. The availability of preference shares on stock exchanges ensures liquidity for investors as they can enter or exit from their positions without relying on the company’s internal processes, like buyback.
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Advantages of investing in preference shares
The key advantages of preference shares are enumerated below:
- Stable income stream: Investors who rely on their investments to generate a consistent income stream, like retirees, are often drawn to preferential issues due to fixed rates of dividends. The predictability of returns on preference shares makes them more appealing to investors.
- Asset protection: Preferential issues can safeguard your investment and a preferential claim over the company assets.
- Resilient portfolios: Preference shares can help investors to diversify their investment portfolios. It can bring a balance between income and growth, allowing investors to create a more resilient portfolio.
- Low risk: As preferential issues are offered with the feature of prioritisation at the time of liquidation, there is low risk for investors.
Disadvantages of investing in preference shares
- Potential for lower returns: When compared to common shares, preferential issues have the potential to offer lower returns. Even if the company performs well and makes significant profits, there will be the same rate of dividends offered to preferential shareholders.
- Vulnerability to changes in interest rates: Changes in interest rates can affect the attractiveness of preference shares. As interest rates surge, fixed-income products or debt securities may provide higher yields. It can make the fixed dividends of preferential issues less appealing relatively.
Thus, strategic investing in preference shares can offer a balanced blend of security and return potential, making them an intriguing proposition for most individuals interested in the stock market.
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