Investors are increasingly turning towards the stock market to fulfil their financial aims. Because the Indian stock market has maintained a certain level of consistency in delivering returns. But it is essential to conduct thorough research about stocks before investing. It is because stock investment comes with relatively high risks and there are multiple stocks with different features.
Shares are broadly categorised into equity and preference shares. The following sections of this blog will explore the meaning of preference shares and other important details.
What are preference shares?
Preference shares, also called preferred stock, are company shares that get dividends before common stock. If the company goes bankrupt, preferred shareholders are paid from the company's assets before common shareholders. Although they usually don’t have voting rights, preferred shares ensure holders receive their dividends first.
Investors who have been trading in the stock market for a long time often choose preference shares. The dividends from these shares are much higher than those from ordinary shares. Many preference shareholders own only this type of stock, which shows its popularity.
More companies are now offering different types of preference shares. These shares have equity and debt characteristics, making them hybrid financing instruments.
Features of preference shares
Here are the features of preference shares:
1. Dividend payout
Preference shareholders are entitled to receive dividends at a fixed rate before any dividends are paid to common shareholders. If a company announces dividends, preference shareholders will be the first to receive them without exceptions. Furthermore, for cumulative preference shares (a type of preference shares), if a company can't pay dividends in a year, the unpaid amount adds up. The company must pay the pending dividends to preference shareholders before any dividends are given to common shareholders.
2. No voting rights
Preference shares do not give any voting rights to the shareholders. Thus, preference shareholders do not have a say through voting in business operations or the decision-making process. The absence of voting rights is also one of the main reasons companies offer preference shares to investors, as they do not want shareholders to influence the company's operations and decisions.
3. Fixed income
Companies that offer preference shares are liable to pay dividends to the preference shareholders at regular intervals on a pre-determined date. Hence, preference shares are similar to fixed-income securities because they offer regular, pre-determined dividend payments. The fixed-income nature makes them ideal for investors who want to earn guaranteed monthly income.
4. Additional features
Investors can buy a type of preference share known as redeemable preference shares. Companies have the right to buy these shares back after a certain period or on a specific date. Furthermore, a company can also issue callable preference shares, where it has the right to repurchase them at a predetermined price after a specific date.
Reasons to invest in preference shares
After understanding the meaning of preference shares, an investor will want to know why he/she should invest in them:
- Yields regular returns
A salient benefit of these shares is that it yields regular returns in the form of dividends. But investors must note that the consistency of these dividend payouts depends entirely on the type of preference share. - Carries lower risks
Preference shares are associated with lower risk compared to common shares. If the issuing company closes, the preference shareholders will receive compensation first.
Bankruptcy or closing of a company is the highest risk an investor can take. But people who invest in preference shares take lower risks of losses of the principal amount.
Potential investors should also be aware of the disadvantages of preference shares. Fixed dividend obligation is a significant limitation because it exerts tremendous pressure upon the company. Moreover, these shares have less potential for capital appreciation, which is a major disadvantage for investors.
Types of preference shares
Here are the types of preference shares:
1. Cumulative preference shares
Cumulative preference shares are shares that allow shareholders to receive pending dividends that the company did not pay in any of the previous years. If a company fails to earn profits and cannot pay dividends to preference shareholders, the guaranteed dividend amount is deemed pending. The unpaid dividends accumulate, and the company must pay the dividends to cumulative preference shareholders before distributing them to common shareholders.
2. Non-cumulative preference shares
Non-cumulative preference shares entitle shareholders to dividends before common shareholders. However, their dividend payout must be from the company's annual profit. If the company does not make profits and skips paying dividends, non-cumulative preference shareholders do not have the right to claim those missed dividend payments in the future. This type of preference share carries more risk than cumulative preference shares, as there is no guarantee of receiving unpaid dividends in the future.
3. Redeemable preference shares
Redeemable preference shares are a type of preferred stock that the issuing company can buy back after a specified period and on a specific date. These shares come with a predetermined redemption price and date. For investors, redeemable preference shares provide transparency on when they will receive the fixed dividends until the shares are redeemed.
4. Irredeemable preference shares
Irredeemable preference shares, also known as perpetual preference shares, are the opposite of redeemable preference shares. Such shares do not have a set redemption date, and the company can not buy them back. The only time the company can buy such shares is at the time of liquidation or when the company stops its business operations.
5. Participating preference shares
Participating preference shares are considered one of the best types of preference shares for investors who want to earn extra income. Participating shares provide shareholders with the right to receive extra dividends in addition to their fixed dividend amount. These additional dividends are mostly distributed when the company earns profits above a predefined amount. Furthermore, participating preference shareholders have the right to the surplus assets of companies at the time of liquidation.
6. Non-participating preference shares
Non-participating preference shares do not allow shareholders to receive extra dividends over the fixed dividend rate. Shareholders of these shares receive their predetermined dividend payment irrespective of the company’s financial performance. Non-participating preference shares offer a stable income to shareholders but do not provide higher earnings than participating preference shares.
7. Convertible preference shares
Convertible preference shares offer the shareholders the option to convert their preference shares to common shares. These types of shares provide the benefit of earning from the fixed dividends of preference shares while still offering the benefit of earning through capital appreciation by converting the shares to common shares if the stock price is increasing substantially. Convertible preference shares provide a blend of fixed income and potential for growth, where investors can convert them at their convenience.
8. Non-convertible preference shares
Non-convertible preference shares are a type of preference share that does not give shareholders the option to convert them into common stocks. Hence, these types of shares do not offer the potential for capital appreciation through conversion to common shares. They only extend fixed dividend payments, similar to other types of preference shares.
9. Preference shares with a callable option
Callable preference shares are those that a company can buy back or call in at a set date and a pre-determined price. The company mentions the call price (the price at which the shares are bought back) and the call date in the company prospectus. For investors, such shares offer a higher income as there is a risk that the company may call the shares before maturity, limiting the dividend income for the investors.
10. Adjustable rate preference shares
Adjustable rate preference shares are those in which the dividend rate is not fixed and changes based on the prevailing market interest rates. This option helps protect investors from interest rate fluctuations and inflation. When the market interest rate increases, the dividend rate increases, offering higher returns to investors. When it falls, investors get a lower dividend payout.
Advantages of preference shares
Here are the advantages of preference shares:
- Fixed income
Preference shares allow shareholders to receive fixed dividends, making up for a steady pre-determined monthly income. This is an effective option for investors who want to earn a steady income without taking on much risk. - Dividend priority
One of the best advantages of preference shares is the priority given to shareholders when it comes to dividend payments. This means that dividends must be paid to preference shareholders before any dividends can be distributed to common shareholders. - Higher liquidation claim
Participating preference shares offer shareholders the right to have a higher claim on the company’s assets at the time of liquidation if the company winds up its operations. This higher claim reduces the risk of losing the entire investment in case the company faces financial distress. - Convertible options
Convertible preference shares offer shareholders the option to convert their preference shares to common shares. This option allows shareholders to receive regular dividends from their preference shares and earn through capital appreciation of the shares when they convert them to common shares.
Disadvantage of preference shares
Here are the disadvantages of preference shares:
- Limited voting rights
One of the biggest disadvantages of preference shares is that the shareholders do not get any voting rights. Although they receive fixed dividends, they can not vote and do not have any say in the company's operations and decision-making. - Fixed dividend returns
Preference shareholders do not benefit from the company’s increased profits beyond their fixed dividend rate. It is because they only receive a fixed dividend every year, missing out on potentially higher returns that common shareholders might get through higher dividend payouts based on the company earning high profits. - Call risk
Callable preference shares carry the risk of being called in by the company at a predetermined price after a certain date. This introduces call risk, where the company may choose to buy back the shares when interest rates decline. This may force the shareholders to reinvest the buyback amount at lower dividend rates, potentially reducing their income. - Inflation risk
Preference shares carry inflation risk, as the shareholders receive a fixed amount even when the inflation rate is high. This can lower the real value of the dividend income over time and reduce the purchasing power of shareholders.
Conclusion
To sum up, if someone is searching for an investment option that generates consistent cash flow, they can choose preference shares. Apart from offering a company's ownership, these shares also enable shareholders to receive preferential treatment, as against equity shareholders.
Investors should understand the meaning of preference shares and the benefits of each type of these shares before choosing an option most aligned with their investment goals.
