Pros and Cons of Preference Shares: A Complete Investor’s Guide

Share trading often includes various types of financial instruments, among which preference shares, also known as preferred stock, stand out due to their unique characteristics. Unlike common stock, preference shares blend features of both equity and debt, making them a form of hybrid security. These shares offer a fixed dividend, providing investors with a predictable income stream, while also granting companies a flexible means of raising capital without diluting ownership significantly.

Types of Preference Shares

Preference shares come in various forms, each catering to different investment needs and company objectives. Understanding these types can help investors like you and businesses make better decisions:

1. Cumulative preference shares: These shares entitle holders to receive dividends, including arrears, before any distribution to equity shareholders. If a company skips dividend payments in a year, they accumulate and must be paid in subsequent years.

2. Non-cumulative preference shares: Unlike cumulative shares, these do not accumulate unpaid dividends. If the company cannot declare dividends in a particular year, shareholders have no claim for that year's unpaid dividends.

3. Convertible preference shares: Holders of these shares have the option to convert them into equity shares after a specified period, offering the potential for capital appreciation.

4. Non-convertible preference shares: These cannot be converted into equity and remain as preference shares throughout their tenure, offering stable dividend income.

5. Redeemable preference shares: These are issued with a fixed maturity date, allowing companies to buy them back after a specific period or upon achieving certain financial goals.

6. Irredeemable preference shares: These have no fixed maturity date and continue indefinitely, offering you a steady income.

7. Participating preference shares: In addition to fixed dividends, holders may receive a share in surplus profits after equity shareholders are paid.

8. Non-participating preference shares: These only offer fixed dividends, with no claim on surplus profits.

Benefits of Preference Shares

1. Dividends are paid first to preference shareholders

The primary advantage for shareholders is that the preference shares have a fixed dividend. This payout is typically done prior to any dividends being paid to common shareholders. If the company turns a profit, the dividends are paid on some types of preference shares. This generally permits for the aggregation of dividends that are unpaid. The preferred shareholders get priority when it comes to remitting unpaid dividends, over common shareholders.

2. Preference shareholders have a prior claim on business assets

If the business decides to file for bankruptcy or liquidates, preference shareholders can stake a higher claim on the assets of the business. This makes the risk of investment tolerable as opposed to the common shareholder. The preferred shareholders have a guaranteed dividend payout annually. In fact, if the business does opt to shut down its operations, the preferred shareholders will be adequately compensated for their investments.

3. Add-on benefits for investors

Preference shareholders are allowed to trade in their convertible shares for a pre-decided number of common shares. If the company is able to meet a specified profit mark that was determined earlier, then the shareholder has the opportunity to experience add-on dividends. This can be an advantageous prospect, especially if the value of common shares starts increasing. In order to generate long-term income, this particular segment of preference shares is low risk and offers additional benefits as a type of investment instrument.

4. Stability in returns

A significant benefit of preference shares is the stability and predictability of income for investors. Unlike common shares, which depend on the company's profit performance and dividend policies, preference shares provide a fixed rate of return in the form of dividends. This makes them particularly appealing to risk-averse investors who value steady cash flow over the potential for high, but uncertain, returns. Additionally, this predictability can help investors plan their finances better, knowing they will receive a fixed income at regular intervals.

Disadvantages of Preference Shares

1. There are no voting rights for preference investors

The key disadvantage of owning preferred shares is the absence of ownership rights in the business. From an investor perspective, the business is not liable to preferred shareholders as opposed to equity shareholders. If the business really turns a profit and the interest rate increases, the preferred shareholders will be stuck on the fixed dividend.

2. Higher cost than debt for issuing company

In order to finance projects, businesses will try to raise capital through debt and equity issues which are basically costs associated with operations. Usually, large corporations issue preferred stock to the public in addition to raising funds through the common stock and corporate bonds. Businesses that choose equity in place of debt issues are able to attain a lower debt to equity ratio. This offers them a significant benefit in terms of leveraging for additional financing from new investors.

3. Limited growth potential for investors

While preference shares offer fixed dividends, they lack the potential for significant growth in value that common shares provide. Investors holding preference shares typically do not benefit from the appreciation of the company’s stock price. Even if the company’s performance improves and its stock value rises substantially, preference shareholders will only receive their predetermined dividend without participating in the increased equity value. This limited upside potential can make preference shares less attractive to investors seeking long-term growth opportunities, as the returns are capped and do not align with the company's overall profitability or market performance.

4. Dividend payments are not guaranteed

Although preference shares generally bring fixed dividends, they are not always guaranteed, especially if the issuing company faces financial difficulties. Unlike debt instruments, which legally obligate companies to pay interest, dividend payouts on preference shares can be suspended in cases where the company lacks sufficient profits or cash flow. Cumulative preference shares may accumulate unpaid dividends, but the actual payout might be delayed until the company's financial health improves. This uncertainty can undermine the appeal of preference shares for investors who rely on consistent income, making them riskier than initially perceived.

Preference Shares vs Equity Shares – A Quick Comparison

Conclusion

Preference shares represent a unique investment option that bridges the gap between equity and debt instruments. They offer a blend of benefits such as fixed dividend payouts, priority in asset claims, and lower investment risk, making them an appealing choice for conservative and income-focused investors. However, like any financial instrument, preference shares have their limitations, including the absence of voting rights and a fixed return that might not benefit from high market growth.

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