There is no need to rush into the stock market as a beginner. You must first understand how stock trading works. It is also essential to understand the different types of stocks available in the market, especially common and preference shares. One must choose their stock type based on investment strategy and objective. Let us delve deeper to understand what are preference shares in the market.
What Are Preference Shares?
You might have come across common equity shares in Initial Public Offerings (IPOs) of various companies. Common equity shares are also available on stock exchanges like the NSE and BSE in India. These shares offer voting rights to holders, thus allowing them to participate in company decision-making. Besides common stocks, a company might also issue preference shares. Investors who hold preferred stock of a company are prioritised for dividend payments. It means that the investors holding these shares will receive dividends before the holders of common equity.
Preference shareholders do not have limited ownership as common shareholders. They will even have a claim on the company’s assets in case of liquidation. Some companies might offer ownership of assets in case of liquidation to both common and preferred shareholders. In such a case, preference shareholders are always prioritised over common shareholders.
Types of Preference Shares
Here are the types of preference shares you must know:
These shares are for investors demanding surety of dividend payments. These shares allow investors to receive unpaid dividends for the previous financial year(s). Since companies cannot pay dividends to common shareholders beforehand, they decide to pay preference shareholders in the next financial year.
These do not allow investors to claim dividends from the previous financial year(s). Companies pay dividends to investors with non-cumulative shares from the profit made in the existing year only. If the company is unable to pay dividends in the same year, non-cumulative preference shareholders cannot claim it in the future.
Convertible shares can be converted into common shares after a certain holding period. It allows investors to switch to common shares when their value increases in the market. Besides the minimum holding period criteria, other conditions also exist for the conversion of preference shares into common shares.
As the name suggests, non-convertible shares cannot be converted into common shares throughout the holding period. However, you can sell non-convertible shares based on the company’s terms and conditions.
These shares have a fixed dividend rate. However, companies allow participating preference shareholders to claim the surplus profits. Companies might pay additional dividends to participating preference shareholders beyond the fixed dividend rate. Additional dividends are distributed when common shareholders have received their regular dividends.
Non-participating preference shares do not offer a claim at the surplus profits of the company. They receive a fixed dividend rate. However, the dividend rate of non-participating preference shareholders will be more than that of common shareholders.
These shares do not have a fixed dividend rate. The dividend rate for these shares will depend on the current market interest rates and conditions.
Preference Stocks with Voting Rights
A few companies issue preference shares that offer voting rights, similar to common shareholders.
Now that you have understood what preference shares are, it is time to discuss. Beginners in the stock market must know these preference shares features:
Preference shareholders are prioritised over other shareholders in the company. They are the first to receive dividends from the company.
Most of them do not offer voting rights. It means the shareholder cannot participate in decision-making, director(s) election, or any other company event. This feature can be considered a disadvantage.
Most have a fixed dividend rate, which is more than that of common shareholders. Many companies offer dividends to them on a fixed date. For the same rationale, they feel like they are receiving a timely income.
In case of liquidation of the company, they have a higher claim on the company’s assets. They are prioritised over common shareholders in case of liquidation of the company.
Investors have multiple choices when it comes to these types of shares. Different types of preference shares are available to invest in.
Now that you understand preference shares meaning, here are their benefits:
Companies and shareholders both benefit from them. Companies can issue them when they need immediate funding. It is better to issue new ones than increase the debt ratio.
Investors can develop a fixed income source by investing in them. Companies often pay dividends to them on a fixed date at regular intervals.
Shareholders with them find themselves in a secured position. They are bound to receive dividends before the common shareholders. They also have a fixed dividend rate.
They are prioritised during asset distribution in case of liquidation of the company.
Issuers or companies can diversify their funding sources with them. They do not have to dilute the ownership stakes of common shareholders or their voting rights. They can issue new ones to secure funding.
Why Should You Consider Investing in Preference Shares?
Now that you understand the preference share advantages, let us discuss why you must consider investing in them. You can build a stable source of income by investing in them. You will receive a higher dividend rate at fixed intervals from the issuer. Not to forget, you can future-proof your stock investment with their help. In case of liquidation, you have a claim on the company’s assets. You can cover your lost capital by claiming company assets. Such future-proof stocks are perfect for investors with a low-risk appetite. Since there are several types of preference shares, you will never be short of choice. Even though you might not have voting rights with them, there are numerous other advantages to considering investing.
Like every other financial asset, these shares also have some risks. Beginners in the stock market must understand the risks first before investing. The biggest risk for them occurs during market disruptions. There is no clarity on the dividend amount during market disruptions. Low-risk investors might not prefer these when market volatility is high. Investors can remove this risk by investing in stable companies.
It is crucial to note that dividends usually depend on the company’s Profit After Tax. There might be a risk since dividends are linked with the company’s profitability. When the company does not make a profit, it might fail to pay dividends. Some investors might ignore them, as they offer no voting rights in the company. Also, the value is tied to the fixed dividend rate, thus leaving little room for capital appreciation.
Who is Responsible to Distribute the Corporate Benefits to the IDR Holders?
Foreign companies can raise capital in the Indian market by issuing IDRs (Indian Depository Receipts). A foreign company searches for a domestic depository or a depository bank in India to help them raise capital from Indian investors. The foreign company will issue IDRs representing underlying shares (or other securities), and the domestic depository lists them on stock exchanges. The domestic depository is responsible for holding, listing, and managing the foreign company’s securities. Some investors might have preferred stock of foreign companies via IDR investments. Investors are eligible to receive dividends and experience the other benefits offered by these types of shares. However, the domestic depository is responsible for distributing corporate benefits to IDR holders at regular intervals. The foreign company transfers the benefits to the domestic depository, which is further distributed among shareholders.
Preference shares are perfect for investors who want a fixed dividend rate. Preference shareholders also get to enjoy priority over common shareholders. However, these shares might not offer capital appreciation opportunities. Also, there are no voting rights to be enjoyed by the shareholders. Before investing, beginners in the stock market must understand the pros and cons of preferred stock. Learn more about preference shares now!