Preference Shares

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.

Key Takeaways

  • 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).
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Preference Shares

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.

What are preference shares?

Preference shares, also known as preferred shares, are a type of security that offers characteristics similar to both common shares and a fixed-income security. The holders of preference shares are typically given priority when it comes to any dividends that the company pays. In exchange, preference shares often do not enjoy the same level of voting rights or upside participation as common shares.

What are the main types of preference shares?

There are four main types of preference shares: cumulative preferred, non-cumulative preferred, participating preferred, and convertible. Holders of cumulative preferred shares are entitled to receive dividends retroactively for any dividends that were not paid in prior periods, whereas non-cumulative preferred shares do not carry this provision. For this reason, cumulative preferred shares will generally be more expensive than non-cumulative preferreds. Similarly, participating preferred shares offer the benefit of additional dividends if certain performance targets are reached, such as company profits exceeding a specified level. Convertible preferreds, like convertible bonds, allow the holder to convert their preference shares into common shares at a specified exercise price.

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

If a company goes bankrupt, then the different securityholders in that company will have claim to the company’s assets. The order in which those securityholders receive their share of the assets will depend on the specific rights given to them in their security agreements. Preference shares, for instance, will generally have priority over the common shares, and will therefore be paid before the common shareholders. However, preference shares will generally have lower priority than corporate bonds, debentures, or other fixed-income securities.