Understanding Preference Shares: Types, Features, and Benefits

Preference shares, also known as preferred stock, are a type of equity security that provides investors with a higher claim on assets and earnings than ordinary shares. This article will delve into the types, features, benefits, and risks associated with preference shares, and how they differ from ordinary shares.

What are Preference Shares?

Preference shares are a class of shares that offer specific advantages over ordinary shares, such as fixed dividends and priority in the event of liquidation. They are often considered a hybrid between equity and debt, providing some of the benefits of both.

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Features of Preference Shares

1. Fixed Dividends: Preference shareholders typically receive a fixed dividend, which is paid out before any dividends are paid to ordinary shareholders.
2. Priority in Liquidation: In the event of a company’s liquidation, preference shareholders have a higher claim on the company’s assets than ordinary shareholders.
3. Convertibility: Some preference shares can be converted into ordinary shares at a specified rate.
4. Non-voting Rights: Generally, preference shareholders do not have voting rights in company meetings, although some exceptions exist.
5. Callability: The company can often redeem preference shares after a certain period, paying back the shareholders at a predetermined price.

Difference Between Preference and Ordinary Shares

1. Dividend Payment: Preference shares have fixed dividends, while ordinary shares have variable dividends based on the company’s profitability.
2. Priority in Payments: Preference shareholders receive dividends and capital repayment before ordinary shareholders.
3. Voting Rights: Ordinary shareholders usually have voting rights, whereas preference shareholders typically do not.
4. Risk and Return: Preference shares are less risky and offer fixed returns, while ordinary shares are riskier but have the potential for higher returns.

Types of Preference Shares

1. Cumulative Preference Shares: Unpaid dividends accumulate and must be paid out before any dividends are paid to ordinary shareholders.
2. Non-cumulative Preference Shares: Unpaid dividends do not accumulate. If a company skips a dividend payment, it is lost forever.
3. Convertible Preference Shares: These can be converted into a specified number of ordinary shares after a predetermined period.
4. Non-convertible Preference Shares: These cannot be converted into ordinary shares.
5. Redeemable Preference Shares: The company has the option to buy back these shares after a certain period.
6. Non-redeemable Preference Shares: These cannot be bought back by the company.

How to Buy Preference Shares?

To buy preference shares, follow these steps:

1. Open a Demat Account: You need a demat and trading account with a brokerage firm.
2. Research: Identify companies offering preference shares and understand their terms and conditions.
3. Place an Order: Use your trading account to place an order for the preference shares you wish to purchase.
4. Payment: Complete the transaction by paying the required amount.
5. Hold and Monitor: Hold the shares in your demat account and monitor their performance.

Advantages of Preference Shares

1. Fixed Income: Preference shares provide a steady stream of fixed dividends, making them attractive to income-focused investors.
2. Lower Risk: They are less risky compared to ordinary shares as they have priority over ordinary shares for dividends and in the event of liquidation.
3. Convertible Options: Convertible preference shares provide the flexibility to convert to ordinary shares, offering potential for capital appreciation.
4. Priority: Preference shareholders have priority over ordinary shareholders in receiving dividends and during liquidation.

Risks Associated with Preference Shares

1. Limited Voting Rights: Preference shareholders typically do not have voting rights, limiting their influence on corporate decisions.
2. Fixed Dividend: The fixed dividend may not keep pace with inflation or the company’s profitability.
3. Callability Risk: The company may redeem the shares at an inopportune time for the investor.
4. Credit Risk: In case the company faces financial difficulties, preference shareholders might still face risks despite their priority over ordinary shareholders.

Final Words

Preference shares can be a valuable investment for those seeking steady income with lower risk compared to ordinary shares. However, they come with their own set of risks and limitations. Understanding the features, types, and benefits of preference shares, along with the associated risks, can help investors make informed decisions and effectively integrate these instruments into their investment portfolios.