Preference shares is another type of share other than equity share on which investors can invest their money. Preference shares also known as a preferred share is interesting shares to the investors because of its higher returns.
What is preference shares?
Preference shares are shares that give the holders preferential right to receive their dividend ahead of equity shareholders. The shares give the holders the right to a fixed dividend, but they have no voting rights. However, at the time of the company’s liquidation, preferred shareholders have the right to the assets of the company ahead of ordinary shareholders.
Types of Preference shares
The most common types of preferred shares include:
Cumulative and non-cumulative preference share
Cumulative preferred share gives the investors the right to receive the dividend in arrears. So, if the company failed to pay a dividend in any year, the holders will receive that dividend in the future when the company declares a dividend. Non-cumulative share on the other hand gives the holders no right to receive the dividend in arrears. Therefore, if the company failed to pay a dividend in any year, the holders have no right to receive that dividend in the future when the company declares a dividend.
Redeemable and irredeemable preference shares
A redeemable preference share gives the company to redeem the share at a particular time in the future or by giving prior notice after a particular time. Irredeemable ones on other hand can only be redeemed by the company at the time of liquidation.
Participating and non-participating preference shares
Participating preference shares give the holders the right to receive a fixed dividend and participate in sharing in the surplus profit. The holders of this type of share also have the right to share in the company’s surplus assets at the time of liquidation. While non-participating ones give holders the right to only receive fixed dividends and they can’t participate in sharing in the surplus profit. Also, they don’t have the right to share the surplus assets of the company at the time of liquidation.
Convertible and non-convertible preference shares
Convertible preferred shares give the holders the right to convert their preference shares to equity shares at a particular agreed time. The terms of the conversion will be stated in the contract. Non-convertible shares give the holders no right to convert their preferred shares to equity shares.
Callable preference shares
The company has the right to buy back or call in the shares from the holders of callable preference shares at a predetermined price in the future time. However, the call price, the call date as well as call premium will be written in the prospectus.
Adjustable-rate preference shares
This share gives the holders the right to receive a dividend that is based on the prevailing interest rates in the market. Therefore, the holders don’t enjoy a fixed dividend rate.
Benefits of investing in preference shares
The shares give the investors higher returns due to the higher risk. Therefore, the higher return of the shares is a trade-off for the higher risk. The preferred shareholders enjoy higher returns than the holders of both corporate bonds and equity shares.
The shares give the holders higher income because the holders don’t benefit from the dividend’s growth. Therefore, the capital value of the shares is paid out in the form of a dividend.
The preference share is suitable for low-risk appetite investors who want a certain level of security on their investment. This is because it has a fixed dividend rate. The holders are rank ahead of equity shareholders for the payment of dividends and also have the right to benefit from the distribution of the company’s assets ahead of equity shareholders at the time of liquidation. The convertible one can also be converted to the ordinary share at the future time.
Disadvantages of investing in preference shares
Investing in preference shares involves higher risk. This is because the bondholders are paid ahead of the holders of preferred shares.
The holders of preference shares enjoy lower returns than equity shareholders. This is because the holders don’t benefit from the growth in the dividend and capital value. Therefore, equity shares will yield more money in the long run, if the market condition is favorable.
The persistent increase in the general price can reduce the value of the share because of its fixed returns. So, inflation will reduce the real value of the dividend paid to the investors. Therefore, the investors need to negotiate for a higher return for the trade-off.
The preference share is a good investment option for those investors who want higher income and security for their investment. However, it has its drawbacks that investors must consider when making investment decisions. Therefore, to invest in preference shares make sure that the choice is suitable to your needs and risk appetite.
Afeez is one of the founding partners of Marasas Consulting limited. He consults for both individuals and entities in the area of accounting, management, audit, tax, and investment. He has a wide range of experience both online and offline which allows him to provide relevant and timely professional advice and assistance to business owners with their accounting, tax, management, audit, and investment plans.
Afeez is a member of the Institute of Chartered Accountants of Nigeria (ICAN) and a member of the Nigerian Institute of Management (Chartered). He is a certified Google analyst and strategist. He earned his Bachelor degree in Management and Accounting from Obafemi Awolowo University, Ile-Ife, Nigeria, and earned an ordinary national diploma in Accountancy from The Polytechnic of Ibadan, Oyo State, Nigeria. He earned certification in “Excel Crash Course” and “Reading of Financial Statement” from Corporate Finance Institute, Canada.
Afeez is dedicated to helping clients achieve business success by helping them to establish solid and sound accounting, tax, and financial processes.