Preferred shares are a class of corporate stock that offer specific financial advantages, such as priority in dividend payments and claims on assets over common stockholders. These shares do not give voting rights but provide a more stable income stream, making them appealing to investors seeking dividends.
What Are Preferred Shares?
Preferred shares are a type of share that combines the features of debt and common equity. They provide fixed dividend payments and have priority over common shares in asset and dividend claims during a company’s liquidation. Despite lacking voting rights, they offer investors steady income and safety.
Further detailing, preferred shares often come with a par value and a specified dividend rate, making them a predictable source of income. These dividends are typically higher than those of common shares and can be cumulative, meaning missed dividend payments accumulate and must be paid out before common shareholders receive dividends. In the event of a company’s bankruptcy, preferred shareholders have a higher claim on any liquidated assets than common shareholders, though they stand behind debt holders
Preferred Shares Example
‘Tech Innovations Inc.’ offers preferred shares with a steady 5% yearly dividend. Investors receive regular payments that don’t change with the company’s profits, unlike common shares where dividends can vary depending on how well the company does.
How To Calculate Preferred Shares? – Preferred Stock Formula
Calculating the dividends for preferred shares typically involves applying the dividend rate to the par value of the share. For instance, if a preferred share has a par value of Rs 100 and the dividend rate is 6%, the annual dividend per share would be Rs 6 (100 x 6%).
In numerical terms, if you hold 100 of these preferred shares, your annual dividend income would be Rs. 600 (100 shares x Rs. 6 per share). This formula provides investors with a clear expectation of the income they can expect from holding these shares.
How Does Preferred Stock Work?
Preferred stock functions by providing investors with a fixed dividend, paid out before dividends are distributed to common stockholders. This feature offers a more predictable income, making it attractive to investors prioritizing steady returns.
Key aspects of how preferred stock works include:
- Fixed Dividend Payments: Unlike common stock, which may have variable dividends, preferred stock provides a set dividend rate.
- Priority in Liquidation: In case of company liquidation, preferred shareholders are paid before common shareholders.
- Convertible Options: Some preferred shares can be converted into a predetermined number of common shares.
Features Of Preference Shares
The primary feature of preference shares is their fixed dividend, which offers investors a consistent and predictable income. Unlike common stock dividends, which fluctuate with company performance, preference share dividends are set at a fixed rate, providing stability and certainty to income-focused investors.
Further features include:
- Dividend Preference: preference shares have priority over common shares for dividend payments, ensuring dividends even during tight financial periods.
- Liquidation Preference: In company liquidation scenarios, preference shareholders are prioritized over common shareholders for asset distribution.
- Convertible Feature: Some preference shares offer the option to convert into common shares.
- Non-Voting Rights: Holders usually don’t have voting rights in company decisions, focusing more on financial benefits.
Types of Preference Shares
There are several different types of preference shares, each of which has its own set of distinguishing characteristics:
- Cumulative Preference Shares
- Non-Cumulative Preference Shares
- Participating Preference Shares
- Convertible Preference Shares
- Redeemable Preference Shares
- Adjustable-Rate Preference Shares
Cumulative Preference Shares
Cumulative Preference shares protect investors’ dividends by ensuring unpaid dividends accumulate. If a company skips dividend payments, these shares guarantee payment of the accumulated dividends before any dividends are distributed to common shareholders.
These shares are a conservative choice for investors prioritizing dividend security. The accumulation of dividends provides a financial cushion, making these shares a reliable source of income, especially in fluctuating market conditions.
Non-Cumulative Preference Shares
Non-Cumulative Preference shares do not accumulate unpaid dividends. If dividends are missed, they’re not owed in the future, presenting a higher risk for those seeking consistent dividend income.
These shares might be preferred by investors willing to trade dividend security for other benefits that the company may offer. The risk of losing dividend income is balanced by potential other advantages, such as higher dividend rates or prioritized capital repayment.
Participating Preference Shares
Participating Preference shares offer fixed dividends plus potential additional dividends based on the company’s financial performance. This aligns shareholder interests with the company’s success.
These shares provide a dual benefit of fixed income and potential for extra earnings, making them attractive for investors seeking both stability and the opportunity for higher returns linked to company performance.
Convertible Preference Shares
Convertible Preference Shares allow conversion into a specific number of common shares at predetermined times and prices. This flexibility can lead to gains from share price appreciation.
These shares offer a strategic choice for investors, these shares combine the security of preference shares with the growth potential of common shares. This conversion feature is particularly appealing in a rising market.
Redeemable Preference Shares
Redeemable Preference shares are characterized by the issuer’s right to repurchase them at a predetermined price and time. This offers companies flexibility in managing their capital structure.
These shares are advantageous for companies seeking control over their share structure. For investors, they offer predictable returns with a set redemption period, but the trade-off is potential loss of long-term income if the shares are redeemed early.
Adjustable-Rate Preference Shares
Adjustable-Rate Preference Shares have dividends tied to benchmark interest rates, resulting in variable payouts. This feature offers adaptability to changing economic conditions, particularly inflation and interest rate shifts.
These shares are an attractive option for investors looking to hedge against interest rate volatility. They provide a flexible income source, adjusting in line with market changes, which can be particularly advantageous in environments of rising interest rates or inflationary pressures.
Advantages Of Preferred Shares
A major advantage of preferred shares is the provision of steady and often higher dividends compared to common shares. This feature ensures a regular income stream for investors, making them a reliable option, particularly during economic instability.
Additional advantages include:
- Capital Appreciation Potential: Preferred shares provide an opportunity for capital appreciation. They can be converted into common shares, potentially leading to gains if the company’s stock price rises. This offers a blend of income and growth possibilities.
- Reduced Volatility: Preferred shares typically exhibit less price volatility than common stocks, making them a more stable investment choice. This stability appeals to conservative investors seeking to minimize the risk of substantial price fluctuations in their portfolios.
- Priority in Asset Liquidation: In the event of a company’s liquidation, preferred shareholders have a higher claim on the company’s assets and earnings than common shareholders. This priority provides an additional layer of security for their investment.
- Fixed Dividend Rate: Preferred shares often come with a fixed dividend rate, providing clarity and predictability in income generation. This fixed rate shields investors from the dividend variability often seen in common stocks, aligning well with income-focused investment strategies.
Disadvantage Of Preference Shares
A key disadvantage of preference shares is their capped dividend, which limits the potential for capital appreciation compared to common shares, whose dividends can increase with the company’s profitability.
Other disadvantages:
- Lack of Voting Rights: Preference shareholders typically do not have voting rights in company governance. This exclusion means they cannot influence important corporate decisions, including those that could affect the value and security of their investment.
- Market Sensitivity: Some types of preferred shares are particularly sensitive to changes in interest rates. When interest rates rise, the value of these shares can decrease, making them more volatile in certain market conditions compared to other types of shares.
Preferred Shares Vs Common Shares
The main difference between preferred shares and common shares is that preferred shares offer fixed dividends and priority during liquidation but usually lack voting rights. In contrast, common shares offer voting rights and dividends that can grow with the company’s profits, but they come with higher risk and lower priority in liquidation scenarios.
| Parameter | Preferred Shares | Common Shares |
| Dividends | Fixed rate, offering predictable returns. | Variable, dependent on company profits. |
| Liquidation Priority | Higher claim on assets during liquidation. | Lower priority after preferred shareholders. |
| Voting Rights | Typically no voting rights. | Usually come with voting rights in corporate decisions. |
| Capital Appreciation | Limited potential due to fixed dividends. | Higher potential with company growth. |
| Risk | Generally lower risk due to fixed returns. | Higher risk, tied closely to company performance. |
| Convertibility | Can be convertible into common shares. | Non-convertible. |
| Market Sensitivity | Less sensitive to market fluctuations. | More sensitive to market changes and company performance. |
How To Buy Preferred Stock?
To buy preferred stock, investors typically start by opening a brokerage account, similar to purchasing common stocks. Through these accounts, one can easily search, select, and transact preferred shares listed on stock exchanges. This method offers accessibility and ease of transaction for various investors.
- Research: Conduct thorough research to identify preferred stocks that fit your investment strategy. Consider factors like dividend yield, company financials, and sector performance.
- Use a Brokerage Platform: Open and fund a brokerage account. Utilize its tools and resources to find and select preferred stocks. Place buy orders through the platform to add these stocks to your portfolio.
- Diversify Your Portfolio: Integrate preferred stocks into your wider investment strategy. They can balance income and stability, complementing other investment types like common stocks, bonds, or ETFs.
What Are Preferred Shares? – Quick Summary
- Preferred shares are a category of stock that generally does not grant voting rights; however, they do provide priority in liquidation over common stocks and guarantee fixed dividends.
- Preferred shares is known for their predictable income, come in various types such as cumulative, non-cumulative, and convertible, catering to diverse investment strategies.
- To calculate dividends for preferred shares, use the formula: Dividend = Par Value × Dividend Rate. For example, if a preferred stock has a par value of ₹100 and a dividend rate of 5%, the annual dividend per share would be ₹100 × 5% = ₹5..
- Preferred stock works by giving investors a fixed dividend that is paid out before any dividends are given to holders of common stock.
- The main advantage of preferred shares is their steady income and lower risk profile, while the primary disadvantage is their limited potential for capital growth and the typical absence of voting rights..
- Different types of preference shares include Cumulative, Non-Cumulative, Participating, Convertible, Redeemable, and Adjustable-Rate.
- The difference between preferred and common shares is that preferred shares give you fixed dividends and liquidation priority. While common shares give you the right to vote.
- Buying preferred stock includes thorough research, using brokerage platforms for transactions, and integrating them into diverse investment portfolios for risk management.
- Start your investment journey with Alice Blue. Alice Blue’s 15 Rs brokerage plan offers a monthly savings of up to ₹1100. Additionally, you benefit from zero clearing charges, enhancing the efficiency and cost-effectiveness of your stock trading activities.
Preferred Shares – FAQs
What are preferred shares?
Preferred shares are a type of stock that usually does not give you the right to vote but offer fixed dividends and priority in the event of liquidation.
What is an example of a preferred stock?
A company issues preferred stock with a 5% fixed dividend rate, providing stable, predictable returns to shareholders. This means if an investor owns ₹1,000 worth of these shares, they receive ₹50 each year, prioritised over common stock dividends.
What is the duration of preferred shares?
Preferred shares typically do not have a fixed maturity date, unlike bonds. They are designed to provide dividends indefinitely, as long as the company exists and chooses to pay dividends.
Who issues preferred stock?
Corporations issue preferred stock to raise capital without diluting voting power like a common stock.
What is the difference between preferred shares and common stock?
The key difference between preferred shares and common stock is that preferred shares give fixed dividends and priority over common stockholders during company liquidation but usually don’t have voting rights, unlike common stock which offers voting rights and potential variable dividends.
