There are a number of investment options available to those looking to make money in the stock market. Most people probably think of common shares when they think of investing in stocks, but preference shares can also be a lucrative investment vehicle.
Preference shares, also called preferred shares, are so-named because preferred shareholders have a higher claim on the issuing company's assets than common shareholders. In the most extreme case, this means that preferred shareholders must be paid for their interest in the company before common shareholders in the event of company bankruptcy and liquidation.
The day-to-day implication of this claim is that preferred shares guarantee dividend payments at a fixed rate, while common shares have no such guarantee. In exchange, preferred shareholders give up the voting rights that benefit common shareholders.
- Preferred shares are a hybrid form of equity that includes debt-like features such as a guaranteed dividend.
- The four main types of preference shares are callable shares, convertible shares, cumulative shares, and participatory shares.
- Each type of preferred share has unique features that may benefit either the shareholder or the issuer.
Callable shares are preferred shares that the issuing company can choose to buy back at a fixed price in the future. This stipulation benefits the issuing company more than the shareholder because it essentially enables the company to put a cap on the value of the stock.
If the company retains the right to repurchase callable shares at $45 a share, it may choose to buy out shareholders at this price if the market value of preferred shares looks like it might exceed this level. Callable shares ensure the company can limit its maximum liability to preferred shareholders.
Convertible shares are preferred shares that can be exchanged for common shares at a fixed rate. This can be especially lucrative for preferred shareholders if the market value of common shares increases.
Assume an investor purchases five shares of convertible preferred stock at $50 per share, and one share of preferred stock can be converted to three shares of common stock. Profit can be made on the initial $250 investment if the five preferred shares are converted to 15 common shares when the value of common shares moves above $17 ($17 * 15 = $255).
Once the shares have been exchanged, the shareholder gives up the benefit of a fixed dividend and cannot convert common shares back to preferred shares.
Preference shares that include a cumulative clause protect the investor against a downturn in company profits. If revenues are down, the issuing company may not be able to afford to pay dividends. Cumulative shares require that any unpaid dividends must be paid to preferred shareholders before any dividends can be paid to common shareholders.
If a company guarantees dividends of $10 per preference share but cannot afford to pay for three consecutive years, it must pay a $40 cumulative dividend in the fourth year before any other dividends can be paid.
However, participatory shares guarantee additional dividends in the event that the issuing company meets certain financial goals. If the company has a particularly lucrative year and meets a predetermined profit target, holders of participatory shares receive dividend payments above the normal fixed rate.