PREFERENCE SHARES | LEARN ALL ABOUT PREFERENCE SHARES, EXPLORE THEIR FEATURES, TYPES, ADVANTAGES, RISKS AND VALUATION.
Preference shares are a type of security issued by a company to raise capital. They represent interest to the holder of the shares in the company but come with distinct features that differentiate them from ordinary shares.
These shares combine equity and debt features, offering investors a fixed dividend, priority in dividend payments over ordinary shareholders, and, in some cases, the option to convert them into ordinary shares.
The key attraction of preference shares lies in their promise or commitment of stable income, making them an ideal choice for income-oriented investors. They also play a crucial role in a company’s capital structure, providing a source of funds that doesn’t dilute the voting power of ordinary shareholders.
An increasing number of investors are considering preference shares as a viable avenue to achieve substantial long-term returns especially when the rate of return can be higher than the rate of return offered in the market. Preference shares are normally appealed to investors like venture capital firms who want a fixed income investment, the potential for capital growth by converting to ordinary shares at a later date and a smooth exit route. Founder or co-founder of an organisation may also find preference shares as a useful ownership diversification, in addition to ordinary shares that they might owned.
Before investing in preference shares, it is crucial to consider your investment goals, risk tolerance, and the specific terms of the shares you are interested in.
Let’s look at the features of preference shares.
FEATURES OF PREFERENCE SHARES
Here are some key features of preference shares:
- Dividend preference: As the name suggests, preference shares hold a unique “preference” or priority over ordinary shareholders. Preference shareholders have the first claim on the company’s profits. They receive a fixed dividend before common shareholders receive any dividends.
- No voting rights: Unlike ordinary shareholders, preference shareholders typically don’t have voting rights at shareholder meetings. They rely on the board of directors to make decisions on their behalf.
- Priority in liquidation: In the event of a company’s liquidation, preference shareholders are entitled to receive their capital back before ordinary shareholders. This prioritization of returns makes them “preferred shareholders” in this context.
- Redeemable or irredeemable: Some preference shares are redeemable, meaning the company can repurchase them at a predetermined price, while others are irredeemable; the company cannot buy them back.
TYPES OF PREFERENCE SHARES
Now that we have learned the features of preference shares let’s look at the types of preference shares. Different preference shares are tailored to meet diverse investment preferences and risk profiles. Here are some common types of preference shares:
Cumulative preferred share
With cumulative preference shares, if a company fails to pay the promised dividends in a particular period, the unpaid dividends accumulate and must be settled in the future before any dividends are distributed to ordinary shareholders.
This means that even if the company experiences a temporary financial setback and cannot pay dividends to preferred shareholders, it accumulates as debt owed to them, and the company must eventually catch up on these payments when it is financially able.
This feature provides stability and assurance to investors prioritizing a consistent income stream, reducing the risk of missing out on dividends during challenging financial periods.
Non-cumulative preferred shares
Non-cumulative preference shares do not allow for the accumulation of unpaid dividends.
In other words, if the issuing company fails to pay dividends to its non-cumulative preferred shareholders in a particular period, the unpaid dividends are forfeited and do not accumulate or carry over to future periods.
Non-cumulative preferred shareholders receive their fixed dividends only when the company declares and pays them for a specific period. Any missed payments do not create an obligation for the company to pay them back in the future.
This makes non-cumulative preferred stock riskier regarding dividend reliability than cumulative preferred stock, which accumulates unpaid dividends and requires them to be paid to shareholders.
Participating preferred share
Participating preferred shares allow its holders to receive additional dividends beyond the fixed rate specified in the terms attached to the shares. These additional dividends are typically contingent on the company’s financial performance.
In other words, if the company’s profits exceed a certain threshold, participating preferred shareholders have the right to participate in those excess earnings, sharing in the company’s prosperity alongside common shareholders. This feature makes participating preferred shares more appealing to investors looking for the potential of higher returns when the company performs well.
Convertible preferred share
Convertible preferred stock can be changed into ordinary shares of the issuing company based on predefined conditions and terms. This means that holders of convertible preferred shares can exchange their preferred shares for ordinary shares at a specified conversion ratio.
The primary advantage of convertible preferred shares is the potential for capital appreciation. If the company’s share price increases significantly, converting preferred shares into common shares can result in higher returns for the investor. This feature makes convertible preferred shares an appealing choice for those seeking a blend of fixed income and the potential for participation in the company’s growth.
However, it’s important to note that the conversion is typically subject to certain conditions, such as a specified conversion price or period. Investors should carefully evaluate these terms and the company’s performance before converting their preferred shares. Convertible preferred shares are a versatile or hybrid financial instrument that offers income stability and the opportunity for capital gains, making it a valuable addition to an investment portfolio.
The Upside: Advantages of Preference Shares
Now that you’re acquainted with the types of preference shares, let’s explore why you should consider them an investment option. Here are some advantages of preference shares:
- Steady income: Preference shares offer a predictable income stream through fixed dividends, making them attractive for income-focused investors.
- Prioritised returns: In cases of financial distress or liquidation, preference shareholders enjoy a priority in receiving their capital back, offering a level of security.
- Portfolio diversification: Adding preference shares to your investment portfolio can diversify risk and help you achieve a balanced investment strategy.
- Convertible potential: Convertible preference shares provide the opportunity for capital appreciation if the company’s ordinary shares perform well.
The Downside: Risks associated with preference shares
While there are several advantages of preference shares, it’s important to be aware of the associated risks:
- Interest rate risk: The fixed dividends on preference stocks can become less attractive in a rising interest rate environment, as other investments may offer higher yields.
- Lack of voting rights: Preference shareholders do not have a say in the company’s decisions, which can be a disadvantage if the company’s management makes unfavourable choices.
- Market performance: The performance of preference shares can be influenced by market conditions, and their value may fluctuate accordingly.
- Call risk: If you hold redeemable preference stocks, there’s a risk that the company may choose to redeem them, potentially leaving you with fewer investment opportunities.
VALUATION OF PREFERENCE SHARES
Like ordinary shares, preference shares must also be valued by investors before any investment decision is made. Over-valuation or under-valuation of a particular preference share is the key element that must be determined to ensure a good investment. The method of valuing preference shares is somehow different from valuing ordinary shares, largely due to the unique nature of preference shares with varieties of features and terms. The valuation method is similar to how bond is being valued. Usually, when the dividend is somehow fixed over a period, discounting the future dividends over the prevailing interest rate is sufficient to determine its present value, however when dividend has a predictable growth over time, “Gordon growth Model” or “Dividend Growth Model” valuation method should be considered. It is important to note that the value of preference share moves inversely with the movement of interest rate. The higher the prevailing interest rate the lower the value of the preference shares, thus indicate other investment opportunity in the market at that prevailing rate. In short, valuing preference share is not straight forward affairs, especially taking into account the many types and features of preference shares as discussed above. For example, if the dividend payout ratio of the dividend is increasing over time, the risk of missed dividend payment is likely, thus affecting the price of the preference share.
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