Preference Shares: Meaning, Types and Advantages

17 Mar, 2022

6 min read

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This article helps shed light on all that preferred stock entails including its definition, types, advantages and disadvantages.

Exploring Stock Market Offerings

Contrary to what some might assume, the stock market constitutes a wide range of stock types including but not limited to common stock, preferred stock and cyclical stock to non-cyclical stock, growth stock and value stock. Each of these different types of stocks serves a different purpose and may perform differently at different points in time of an economy’s cycle. Furthermore, different stock types are best suited to different investor profiles as different individuals have different thresholds for risk. This article seeks to walk you through all that one particular type of stock i.e., preference shares, entails.

Preference Shares - Meaning

Also called preferred stock, preference shares refer to the shares of a company’s stock that have dividends paid to shareholders prior to dividends being issued to common stockholders. In the event that a company goes bankrupt, holders of preferred stock are given priority in terms of being paid via the sale of company assets. Only after preferred stockholders have been paid are common stockholders paid.

By and large, the dividend attached to most preferred stock is fixed which falls in contrast to common stocks which don’t have a fixed dividend tethered to them. Another characteristic trait associated with preferred stock is the fact that they ordinarily don’t provide shareholders with voting rights which common stock does.

Types of Preference Shares

Preferred stock can be categorized in four different ways i.e., convertible preferred stock, participating preferred stock, cumulative preferred stock, and non-cumulative preferred stock. Each of these has been examined below.

Cumulative Preferred Stock

Cumulative preferred stock features a stipulation that makes it a must for the company to pay its shareholders all dividends including those that were previously omitted, prior to common stockholders being able to be issued their dividend payments. While these dividend payments are guaranteed they aren’t always paid at the time they are due. Owing to this very fact, such dividend payments are called “dividends in arrears” and they must be made to the current legal owner of the stock at the time of payment. On occasion, an interest may be awarded to cumulative preferred stockholders.

 

Non-Cumulative Preferred Stock

On the other hand, non-cumulative preferred stock doesn’t issue any unpaid or omitted dividends. In case a company decides not to pay dividends for a given year, such shareholders aren’t entitled to claim such forgone dividends in the future.

Convertible Preferred Stock

This kind of stock features an option that permits shareholders to convert their preferred shares into a set number of common shares. Ordinarily, this conversion can occur at any point in time following a pre-established date. Ordinarily, convertible preferred shares are converted in this manner upon the shareholder’s request. That being said, a company may have a provision in place that enables the shareholders of such stock to force the issue. The value of a convertible common stock is tethered to how the common stock performs.

Participating Preferred Stock

Shareholders of this stock are given the right to be paid dividends that amount to the same value as the ordinarily specified rate of preferred dividends in addition to an additional dividend that is determined keeping in mind a preset condition. This additional dividend is ordinarily made to be paid only in instances of the number of dividends received by common shareholders exceeds the predetermined per-share value. In case a company is liquidated, such shareholders may have the right to be paid the purchasing price of the stock in addition to a pro-rata share of the remaining proceeds that were given to common shareholders.

Exploring the Merits and Demerits of Preferred Stock

The advantages associated with preferred stock have been briefly touched upon below.

Greater Claim on Company Assets

Preferred shareholders have a greater claim on company assets in contrast to common stockholders in the event that a company experiences bankruptcy.

Additional Investor Benefits

Convertible preferred stock entitles investors to trades these types of preference shares in return for a fixed number of common shares. In case the value of these common shares begins to rise, this trade can be particularly lucrative.

The primary disadvantage associated with preferred stock is the fact that preferred stockholders don’t have access to the voting rights enjoyed by common stockholders. This results in the company not being beholden to such shareholders in the way that it might be to traditional equity shareholders.

Wrapping Up

Companies often issue preferred stock as it benefits them in a number of ways. For starters, the lack of voting rights they provide such shareholders with allows the company to retain strength as they have more control over its functioning. Additionally, with callable preferred stock, companies have the right to repurchase shares whenever they see fit. As an investor, it is important to thoroughly assess your own investor profile prior to investing in preferred stock.

 

Disclaimer: This blog is exclusively for educational purposes and does not provide any advice/tips on investment or recommend buying and selling any stock.

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