What Are Preference Shares?
Preference shares, also known as preferred stock, are a class of equity securities that represent ownership in a company but possess characteristics of both common stock and debt. As a hybrid instrument within the broader category of equity securities, preference shares typically offer a fixed dividend payment, which takes precedence over dividends paid to common shareholders. In the event of a company's liquidation, holders of preference shares have a higher claim on the company's assets than common stockholders, but their claims are subordinate to those of bondholders. Unlike common stock, preference shares usually do not carry voting rights.
History and Origin
The concept of preference shares emerged in the mid-19th century in the United States, as companies sought flexible ways to raise capital. One of the earliest documented issuances was by the Pennsylvania Railroad Company in the 1850s, which used this new form of security to attract investors by offering a more secure claim to dividends and assets than common stock.4 Over time, preference shares became a common financing tool, particularly for public utilities and transportation companies, growing significantly in popularity by the 1920s.3 They offered a balance between the stable income of bonds and the potential for equity participation, appealing to a wide range of individual and institutional investors.
Key Takeaways
- Preference shares typically provide a fixed dividend payment that takes priority over common stock dividends.
- In a company's liquidation, preferred shareholders have a senior claim on assets compared to common stockholders, but they are subordinate to bondholders.
- Preference shares generally do not confer voting rights, allowing companies to raise capital without diluting control.
- They are often considered a hybrid security due to their blend of debt-like income characteristics and equity ownership features.
Formula and Calculation
The most common "formula" related to preference shares involves calculating their yield, particularly the dividend yield, which expresses the annual dividend payment as a percentage of the share's current market price.
Annual Dividend Yield for Preference Shares:
For example, if a preference share pays an annual dividend of $2.50 and currently trades at $50.00 per share, its dividend yield would be:
This calculation helps investors compare the income generation of different preference shares or other fixed income investments.
Interpreting Preference Shares
Interpreting preference shares involves understanding their hybrid nature and their position within a company's capital structure. For investors, preference shares are often seen as a way to gain consistent income streams, similar to interest payments from bonds, but with the potential for some capital appreciation. The fixed dividend rate means that their price tends to be more sensitive to changes in interest rates, similar to bonds, rather than solely driven by the company's earnings growth like common stock.
From an issuer's perspective, preference shares can be a way to raise equity capital without diluting the voting rights of existing common shareholders. The ability to defer dividend payments on non-cumulative preference shares without triggering a default, unlike bond interest, also provides a measure of financial flexibility. However, missed cumulative preference dividends must be paid before any common dividends.
Hypothetical Example
Consider "Alpha Corp," which decides to issue preference shares to raise capital for a new expansion project. Alpha Corp issues 1 million preference shares with a par value of $100 and an annual dividend rate of 6%. This means each preference share pays a fixed annual dividend of $6 ($100 * 6%).
If an investor, Sarah, purchases 100 preference shares at their par value of $100 per share, her initial investment is $10,000. Each year, she can expect to receive $600 in dividends ($6 per share * 100 shares).
In the scenario where Alpha Corp faces a temporary financial downturn and decides not to pay any dividends in a particular year, if Sarah holds cumulative preference shares, the $6 per share dividend for that year would accrue. Alpha Corp would be required to pay Sarah the missed $6 per share, plus the current year's $6 per share, before it could pay any dividend to common shareholders in a future period. If Alpha Corp were to liquidate, Sarah, as a preference shareholder, would have a claim on the company's assets for her initial $10,000 investment plus any accrued unpaid dividends, after bondholders are paid, but before common shareholders receive anything.
Practical Applications
Preference shares are used across various sectors for different strategic purposes. They are particularly prevalent in industries such as banking, utilities, and insurance, where companies often seek to strengthen their regulatory capital while managing their debt-to-equity ratios. For instance, during the 2008 financial crisis, the U.S. Treasury's Troubled Asset Relief Program (TARP) involved the government purchasing preferred stock in banks to inject capital and stabilize the financial system.
In corporate finance, convertible preference shares can be used by companies looking to raise capital with a lower initial dividend yield than straight preferreds, offering investors the future option to convert their shares into common stock, benefiting from potential capital appreciation if the common stock performs well. Some preference shares are also callable, meaning the issuer can repurchase them at a specified price, similar to callable bonds, providing flexibility to refinance at lower rates or optimize their capital structure.
Limitations and Criticisms
Despite their advantages, preference shares have limitations and face certain criticisms. For investors, while they offer priority in dividends and liquidation, they typically lack the significant upside potential of common stock, as their dividends are usually fixed and they do not generally participate in the company's rapid growth. Furthermore, the absence of voting rights means preferred shareholders have little to no say in corporate governance or strategic decisions. This can limit their influence, especially during periods of financial distress.
From the issuing company's perspective, dividends paid on preference shares are generally not tax-deductible as an expense, unlike interest payments on debt. This can make them a more expensive form of financing compared to debt. Additionally, the complex nature of preference shares, often incorporating various features like convertibility, callability, or participation rights, can make them less straightforward for investors to understand compared to simpler common stock or bonds. The Investment Company Act of 1940 also imposes specific regulations on how certain investment companies can issue and manage preferred securities, adding a layer of compliance.2 The hybrid nature of preference shares can also lead to complexities in legal theory regarding preferred stock, particularly concerning their classification as either debt or equity in different legal and accounting contexts.1
Preference Shares vs. Common Stock
Preference shares and common stock are both forms of equity, but they differ significantly in their rights and characteristics:
| Feature | Preference Shares | Common Stock |
|---|---|---|
| Dividend Rights | Priority in receiving fixed dividends; often cumulative. | Dividends are variable and paid only after preferred dividends. |
| Voting Rights | Generally no voting rights. | Typically carry voting rights, influencing management. |
| Claim on Assets | Higher claim than common stock in liquidation. | Last claim on assets in liquidation. |
| Capital Gains | Limited capital appreciation potential. | Higher potential for capital appreciation. |
| Risk Profile | Lower risk than common stock due to dividend priority and liquidation claim. | Higher risk but greater potential for return. |
While common stock offers the potential for significant growth and shareholder influence through voting rights, preference shares provide a more stable income stream and a preferential position in the event of financial distress. Investors often choose between them based on their investment objectives, whether seeking growth and control or income and relative stability.
FAQs
Are preference shares considered debt or equity?
Preference shares are often considered a hybrid security because they possess characteristics of both debt and equity. They represent ownership like common stock but pay fixed dividends similar to bond interest payments. In a company's financial statements, they are typically listed under equity.
Do preference shares have voting rights?
Generally, preference shares do not come with voting rights. This is a key distinction from common stock and allows companies to raise capital without diluting the control of existing common shareholders. However, some specific issues of preference shares might grant limited voting rights under certain extraordinary circumstances.
What happens if a company misses a preference dividend payment?
If a company misses a preference dividend payment, the consequences depend on whether the shares are cumulative or non-cumulative. For cumulative preference shares, the missed dividends accumulate and must be paid in full before any dividends can be paid to common shareholders. For non-cumulative preference shares, the missed dividend is usually lost and does not accumulate.
Why would a company issue preference shares instead of bonds or common stock?
Companies issue preference shares for several reasons. They can be a way to raise capital without incurring additional debt and affecting the company's debt-to-equity ratio, or without diluting the voting power of existing common shareholders. They appeal to investors seeking consistent income and a preferential claim in liquidation compared to common stock, offering a balance between the risk and return profiles of pure debt and common equity.
Can preference shares be converted into common stock?
Yes, many preference shares are convertible securities. This means they can be exchanged for a predetermined number of common shares, typically at the option of the shareholder. This feature offers investors the potential to participate in the company's growth and capital appreciation if the common stock price increases.