What Are Preference Shares?
Preference shares, more commonly referred to as preferred stock, are shares of a company’s stock with dividends that are paid out to shareholders before common stock dividends are issued. If the company enters bankruptcy, preferred stockholders are entitled to be paid from company assets before common stockholders. Most preference shares have a fixed dividend, while common stocks generally do not. Preferred stock shareholders also typically do not hold any voting rights, but common shareholders usually do.
Understanding Preference Shares
Preference shares fall under four categories: cumulative preferred stock, non-cumulative preferred stock, participating preferred stock and convertible preferred stock.
Cumulative preferred stock includes a provision that requires the company to pay shareholders all dividends, including those that were omitted in the past, before the common shareholders are able to receive their dividend payments. These dividend payments are guaranteed but not always paid out when they are due. Unpaid dividends are assigned the moniker "dividends in arrears" and must legally go to the current owner of the stock at the time of payment. At times additional compensation (interest) is awarded to the holder of this type of preferred stock.
Quarterly Dividend = [(Dividend Rate) x (Par Value)] ÷ 4
Cumulative Dividends per share = Quarterly Dividend x Number of Missed Payments
Non-cumulative preferred stock does not issue any omitted or unpaid dividends. If the company chooses not to pay dividends in any given year, the shareholders of the non-cumulative preferred stock have no right or power to claim such forgone dividends at any time in the future.
Participating preferred stock provides its shareholders with the right to be paid dividends in an amount equal to the generally specified rate of preferred dividends, plus an additional dividend based on a predetermined condition. This additional dividend is typically designed to be paid out only if the amount of dividends received by common shareholders is greater than a predetermined per-share amount. If the company is liquidated, participating preferred shareholders may also have the right to be paid back the purchasing price of the stock as well as a pro-rata share of remaining proceeds received by common shareholders.
Convertible preferred stock includes an option that allows shareholders to convert their preferred shares into a set number of common shares, generally any time after a pre-established date. Under normal circumstances, convertible preferred shares are exchanged in this way at the shareholder's request. However, a company may have a provision on such shares that allows the shareholders or the issuer to force the issue. How valuable convertible common stocks are is based, ultimately, on how well the common stock performs.
- Preference shares (preferred stock) are company stock with dividends that are paid to shareholders before common stock dividends are paid out.
- There are four types of preferred stock - cumulative (guaranteed), non-cumulative, participating and convertible.
- Preference shares are ideal for risk-averse investors and they are callable (the issuer can redeem them at any time).
Significance to Investors
Preference shares are an optimal alternative for risk-averse equity investors. Preference shares are typically less volatile than common shares and offer investors a steadier flow of dividends. Also, preference shares are usually callable; the issuer of the shares can redeem them at any time, providing investors with more options than common shares. (For related reading, see "Preference Shares vs. Debentures: What’s the Difference?")