Investors are increasingly turning towards the stock market to fulfil their financial aims. Because the Indian stock market has maintained a certain level of consistency in delivering returns. But it is essential to conduct thorough research about stocks before investing. It is because stock investment comes with relatively high risks and there are multiple stocks with different features.
Shares are broadly categorised into equity and preference shares. The following sections of this blog will explore the meaning of preference shares and other important details.
Preference shares - Meaning
One can define preference shares as shares that receive preference over common shares in terms of dividend payout. When a company earns profits and decides to pay dividends, its preference shareholders are the first people to receive the payment. Only after the company finishes paying dividends to every preference shareholder is when it will move on to pay other shareholders.
Suppose a company decides to enter the liquidation process. Here, its preference shareholders will receive full payment before any equity shareholders get paid. But people who own preference shares do not have voting rights; therefore, they cannot take part in the internal decision-making process of a company.
Features of Preference Shares
Some of the main characteristics of preference shares are discussed below:
- The benefit of regular dividend payouts
Preference shareholders have preferential rights to receive dividends before equity shareholders. They are the first to receive dividend payouts before common shareholders. - Preference shareholders don’t have voting rights
Preference shareholders don’t have voting rights and, subsequently, no say in the policy-making process of a company. However, they have a right to vote for matters related to their preferential rights/ extraordinary events. - Can be converted to common stocks
Investors can convert some types of preference shares into common stocks. Generally, if preference shareholders want voting rights and wish to have a say in a company's decision-making, they need to convert preference shares to equity or common shares.
Types of preference shares
This section will explore what the types of preference shares are:
- Convertible preference shares
Preference shares that are easily convertible into equity shares are known as convertible preference shares. - Non-convertible preference shares
Preference shares that a person cannot convert into equity shares are referred to as non-convertible preference shares. - Redeemable preference shares
There are certain preference shares that the issuing company repurchases/ redeems at a fixed rate on a pre-decided date. These shares are referred to as redeemable preference shares. During periods of high inflation, redeemable preference shares act as a cushion for the company’s share value. - Non-redeemable preference shares
An issuing company cannot purchase these preference shares at a fixed rate on a given day in the future. This is the reason they are known as non-redeemable preference shares. These shares offer more protection to investors as the issuer cannot buy back the shares and reissue them with lower dividend yields. - Participating preference shares
Investors who hold participating preference shares can ask for a specific portion of the company's surplus profit at the time of liquidation. Generally, participating preference shareholders can ask for additional profits only after other shareholders have received their dividends. - Cumulative preference shares
This type of preference share enables the shareholders to receive cumulative dividends even if the company isn't earning profits. These dividends fall under arrears for those years when the company has not made any profit. The shareholders receive these arrears on a cumulative basis in the next year when the business yields profits.
Reasons To Invest In Preference Shares
After understanding the meaning of preference shares, an investor will want to know why he/ she should invest in them:
- Yields regular returns
A salient benefit of these shares is that it yields regular returns in the form of dividends. But investors must note that the consistency of these dividend payouts depends entirely on the type of preference share.
Carries lower risks
Preference shares are associated with lower risk compared to common shares. If the issuing company closes, the preference shareholders will receive compensation first.
Bankruptcy or closing of a company is the highest risk an investor can take. But people who invest in preference shares take lower risks of losses of the principal amount.
Potential investors should also be aware of the disadvantages of preference shares. Fixed dividend obligation is a significant limitation because it exerts tremendous pressure upon the company. Moreover, these shares have less potential for capital appreciation, which is a major disadvantage for investors.
To sum up, if someone is searching for an investment option that generates consistent cash flow, they can choose preference shares. Apart from offering a company's ownership, these shares also enable shareholders to receive preferential treatment, as against equity shareholders.
Investors should understand the meaning of preference shares and the benefits of each type of these shares before choosing an option most aligned with their investment goals.
