What are Preference Shares

Last Updated: 23 Jan 2024

The Indian stock market has consistently outperformed almost all other financial instruments in terms of returns. With the inflation rate higher than the returns offered by other financial instruments, investors are looking to invest to reach their financial goals and look towards the Indian stock market to allocate a portion of the capital to enjoy better returns over time.

However, the one mistake almost all beginner investors make is to buy stocks without considering their types or performing adequate research. As diversification is a principle followed by every investor, there are various types of stocks available within the equity market. These types of stocks come with different features, risk profiles, return potential, and legality. For example, an investor looking to invest for a steady income based on dividends may buy common stocks, which can prove counterproductive for the financial plan.

Among various types of stocks, this blog details a type of stock called Preference Shares. In your quest of achieving your financial goals through equity investing, understanding preference shares will prove vital in making informed investment decisions.

What are shares, and who are the shareholders?

In simple words, a share indicates a unit of ownership of a particular company. If you own the shares of a company, it implies that you, as an investor, own a percentage of the issuing company. These shares are listed on the stock exchanges through an Initial Public Offering, and investors can buy and sell them based on their current price. 

If you buy the shares of a company, you become the owner of the company in the proportion of the percentage of bought shares. From the day you buy the shares, you are a shareholder. As a shareholder, you are entitled to receive a portion of the profit of the company. This amount is called the dividend amount, and the company declares it as per its financial performance. The shareholders can sell these shares anytime they want to another investor who would then become the shareholder.

Concept: Preference Shares

As the name suggests, preference shares are those shares that are given priority over others by the company in the process of dividend payout. It means that if the company makes profits and announces dividends, and preferred shares, the shareholders will be the first to receive the payment. Only after preference shareholders are paid the dividends will the company move on to pay other types of shareholders.

Furthermore, if the company enters the liquidation process, preference shareholders are paid in full before any other type of shareholders. However, preference shares do not entitle the shareholders to have voting rights and are not involved in the internal decision-making of the company.

Understanding Preference Shares: Different types of Preference Shares

Preference shares generally come with a fixed dividend payout amount. There are four categories of preference shares:

• Cumulative preferred stocks: These types of preference shares come with the provision of paying the shareholders with a dividend amount that includes any past arrears along with the currently announced payout. Only after this amount is paid to these shareholders can the company pay dividends to common stockholders.
• Non-cumulative preferred stocks: These preference shares do not allow shareholders to get dividend arrears. In simple words, if the company chooses not to pay dividends, these shareholders can not legally bind the company to pay this year’s dividend amount as arrears in the future.
• Participating in preferred stocks: This type of preferred stock allows the shareholders to receive a dividend amount that is equal to the specified rate of preferred dividends added with an amount based on a predetermined condition. Generally, this predetermined condition is when the dividend amount received by the common shareholders exceeds the predetermined per-share amount.
• Convertible preferred stocks: These types of preference shares have an option for shareholders to convert their preference shares into common shares. Most companies have a provision on how the conversion works. However, the conversion is mostly done after a pre-established date by the company.

Features of Preference Shares

Numerous features make preference shares an attractive investment option for investors. Some of the most common features of preference shares are as follows:

• Assets of the company: The preference shares are given the highest priority by the company in case the company is liquidating. These shareholders can claim their portion of the company’s assets before non-preferential shareholders.
• Dividends: All the preference shareholders are paid their dividends irrespective of all other stockholders not receiving dividends. The payouts are generally fixed but can be floating in some situations.
• Powers: Unlike common shares, preference shares do not entitle their holders to voting rights. It means that these shareholders can not have their say in the internal policy-making of the company, even if the policies are negative and can hurt their investments.
• Conversion: Preference shares come with the feature of converting the shares into common stocks. This is generally done if a holder of preference shares wants voting rights which is only possible if they are common stocks.
• Callability: Preference shares have the feature of being called at any time by the company for repurchasing the shares in the future. The process is similar to conversion, where the preference shares can be reissued as specified by the company.

Benefits of the Preference Shares

Here are the benefits of preference shares:

• Low risk: Preferred shares come with the feature where their holders are prioritized at the time of liquidation. Since a company going bankrupt is the highest risk an investor can take, preference shares safeguard the investment of the investor by ensuring that the preference shareholders are prioritized over other shareholders in claiming ownership over the company assets.
• Regular returns: Preference shares accompany the benefit of realizing regular returns based on the dividend amount. However, the regularity of the dividend payout depends entirely on the selected type of preference share.

How to buy Preference Shares?

You would need a Demat and trading account to buy preference shares. You can open a Demat account with IIFL that offers highly competitive prices and unique features in just a few steps:

• Visit www.indiainfoline.com or the IIFL Share trading app. Click on open a trading account» Enter Basic details.
• You will receive a one-time password (OTP) on the mobile number.
• You will receive a link on your registered email ID. You need to enter the OTP received on your registered email id.
• After verifying the OTP, you need to fill out the online Account Opening Form.
• Your Relationship Manager will then contact you for the necessary documentation.
• Once the documentation process is completed, and the forms are received at HO, the account will be opened within 24 hours.

Final Words

Understanding all the types of stocks is vital in deciding which type of stock will be ideal for you based on your investment goals and your risk appetite. However, preference shares can prove to be the ideal entry point for you if you are looking to invest in the equity market. They are low-risk, steady returns and priority status if by any chance the company goes bankrupt. Overall, preference shares are one of the most sought-after types of stocks that can allow you to make profits along with get dividends at regular intervals.

Frequently Asked Questions

1. What happens if you own preference shares in a company that goes bankrupt?

If any company goes bankrupt, it is legally bound to pay back the invested amount of the investors in full. However, at times it happens that even after selling all the assets, the company falls short of paying the investors in full. However, preference shares and their holders are the first ones who the company pays before any other shareholders.

2. Why should you consider investing in preference shares?

Preference shares and their holders are prioritised by the company to pay dividends over other shareholders. Furthermore, as in the case of liquidation, preference shareholders are the first ones who are paid in full; they can prove to be a low-risk investment.