As the name suggests, preference shares are those shares that get preference while distributing the company’s profits as dividends. The Companies Act 2013 states that a company must pay preference shareholders their predefined share of its earnings before the equity shareholders.
Even in the company’s liquidation, dues of preference shareholders are paid ahead of those of the equity shareholders after meeting the outside liabilities. Moreover, the rate of dividend given to preference shareholders is generally higher than what is paid to equity shareholders. As a result, investors in the quest for consistent returns, coupled with the security of capital invested against bankruptcy proceedings, buy preference shares.
This article covers:
- Why do companies issue preference shares?
- Why do investors buy preference shares?
- Different types of preference shares
- Features of preference shares you should know before investing
- How do preference shares work?
- How to make money by investing in preference shares?
- Limitations and risks associated with preference shares worth considering
Why do companies issue preference shares?
Preference shares are a hybrid of bonds and equity. As a result, both the company and the investors can cash out the benefits of both.
Companies always look to keep their debt-equity ratio to the bare minimum. Issuing bonds creates a red flag for the company regarding strict repayment schedules and an unfavourable element in the company’s financial statements.
Preference shares are not debt like bonds but equity instruments. Hence, the company can raise further capital without adding to its total debt owned, thereby keeping the debt-equity ratio in check.
Through preference shares, a company can accumulate the required funds without further diluting the voting powers as it would happen in case of an equity issue.
Why do investors buy preference shares?
Those investors looking for a predetermined rate of return for their investment buy preference shares. Preference shares are in great demand because the dividend yield is consistent. Moreover, in the case of cumulative preference shares, the dividend keeps adding up in case of non-payment in any financial period.
Moreover, the investors are safeguarded in liquidation or voluntary wind up of affairs by the company; the preferred shareholders are paid in priority from the proceeds of the sale of assets in such cases.
Preference shares are more attractive than bonds as the rate of dividend offered is kept higher than interest yielded by the bonds of the same company.
Different types of preference shares
- Redeemable preference shares: the class of preference shares where the company vests the right to buy back their shares. The buyback price is kept attractive for the shareholders, and a prior notice intimating the shareholders about the buyback is issued.
- Irredeemable preference shares: the class of preference shares that the company can only redeem during its liquidation or when it resorts to wind up its operations.
- Non-cumulative preference shares: holders of such shares are entitled to dividends only from the current year profits. If the dividend is not paid during the year (generally, in case of losses incurred by the company), the shareholders cannot ask for it in the future.
- Cumulative preference shares: such shareholders are entitled to dividends no matter what. They would be paid a dividend in arrears out of future profits if they did not pay the dividend in earlier years.
- Participating preference shares: these shareholders are given dividends over and above the predetermined rate when the company posts profits. They are also entitled to share surplus assets of the company during the liquidation of a company.
- Non-participating preference shares: these are paid dividends only at the predetermined rate. They have no business in the surplus profits earned.
Features of preference shares you should know before investing
Superior claim on company’s assets than common equity: Both, in case of paying of dividend out of surplus profits and liquidation, preference shareholders are paid ahead of the equity shareholders.
Fixed returns: While the returns earned by common stockholders depend on the company’s profitability, preference shareholders are paid at a predetermined rate.
Higher returns than bonds of the same company: Preferential shares are offered at a higher dividend rate than the returns provided to bondholders.
How do preference shares work?
Preference shares are a win-win deal for both the investors and the company issuing them. The company gets to raise the desired capital it would have otherwise acquired through debt, the excess of which can be unfavourable. The debt-equity ratio of the company is not impacted when issuing preference shares.
For investors, preference shares are the best available low-risk financial instrument. This is because they get a predetermined rate of return on their investment in preference to the common stockholders.
How to make money by investing in preference shares?
We need to understand that preference shares are no magic wand that would give you sure shot returns. Preference shares have several risks involved, and one needs to be mindful of these risks while investing in preference shares.
The best strategy would be to buy preference shares of different companies instead of staking all your assets in the preference shares of one company. This will spread the risk in your portfolio.
Limitations and risks associated with preference shares
- Unlike equity shareholders, preference shareholders don’t enjoy voting rights, and they don’t have any say in the company’s work. The company is not liable to the preference shareholders apart from their fixed dividend.
- With the rise in interest rates, the predetermined dividend rate might not sound as appealing as it sounded back when you bought the shares.
- In the case of default by the company, the interests of preference shareholders are settled after settling the claims of bondholders and external creditors.
- Owing to a very restricted market for preference shares, it is reasonably tough to sell them in the market.
Preference shares provide an attractive investment avenue for investors. They extend you a priority position in the company while claiming dividends and shares of divisible assets in the event of liquidation. However, those looking to buy preference shares should understand both the bright and dark sides of investment in preference shares.