What is Preference Share?
Preference share or preferred equity is similar to the common share of a company in terms of ownership. However, preferred equity does not hold voting rights. Considering the seniority of company instruments, preference share ranks above common share but below company bonds. In case of bankruptcy, preference shares will be paid before common shareholders. Notably, preference shareholders are paid a fixed dividend on the par value of the preference share.
A preference share is an equity instrument but also has characteristics of a debt instrument such as a fixed payment of dividend and callability. Therefore, preference shares fall on the blurred line between debt and equity and is generally considered hybrid in nature.
Why are Preference Shares issued?
- Unlike common shares, preference shares are not volatile in nature and suitable to market them to institutional investors during an IPO. Investors in preferred equity are also subject to friendly tax provisions on dividends earned.
- Unlike timely payment of interest on bonds issued by the company, dividend on preference share can be paid as per the company’s cash status. The company can pay the cumulative amount of dividends whenever they find it convenient. On the other hand, defaulting on interest payments for bond issues results in a downgrade of the company’s credit standing.
What are the types of Preference Shares?
- Cumulative: A most common type of preferred equity where the dividends, if not paid, are considered in arrears and are given priority over other dividend payments. A preference share can be cumulative or straight
- Callable: Being hybrid security, the issuing company is given the right to redeem the shares at a certain date and price specified at the time of issuance. This characteristic makes preferred equity less appealing to the investors
- Convertible: Shares are convertible to common equity at a certain time and price; considered the most versatile and appealing form of preferred equity with diversified risk exposure
- Participating: Another common classification for preferred equity, where if the shares are participating, they stand a chance to earn higher than the state rate of fixed dividend
What is the similarity between Preference Shares and Bond?
- Interest Rate sensitivity
Like any other fixed-income instrument, preference share is also sensitive to interest rates. If the market is offering higher interest than the rate of dividend, the market value of preference share falls
The preference shares can be called by the issuer, which is essentially redemption of shares, at a certain price and time. This happens when the company has to pay a higher dividend on the shares than the prevailing market rate of interest
Higher ranking instruments which provide security in case of bankruptcy
- Credit Rating
Like bonds, preference shares also have a credit rating issued from credit rating companies such as Moody’s depending on the quality of the company and payment of dividends
What is the difference between Preference Shares and Bond?
Bonds are classified as debt and preference shares as equity
- Payment of dividends
The dividends are fixed but not guaranteed, unlike interest on bonds which have to be paid as per the debt schedule
Preference shares are more liquid as they trade on the stock exchange. Bonds are generally over-the-market securities with a negligible presence on the exchange
What is the similarity between Preference Shares and Ordinary Shares?
Like any other equity instrument, preference shares are paid dividends from profit after tax
What is the difference between Preference Shares and Ordinary Shares?
- Voting rights
Common equity holds voting rights which is not the case for preferred equity
Common shares are not entitled to fixed dividend, the company may or may not announce dividends to common shareholders. However, preferred equity attracts dividends, cumulative or non-cumulative
Preferred equity lacks appeal when it comes to price appreciation. Common shares react actively to market developments on a daily basis. Preferred equity is very fundamental in nature and follows steady price movements and therefore offers mediocre returns.
How is the value of preference shares determined?
Common shares are valued on the basis of future earnings per share. Similarly, preferred equity is entitled to dividends and can be valued as per the sum of the present value of future dividends per share.
If the dividends can be forecasted with precision, they can be discounted to their present value using the required rate of return on the preferred equity. The required rate of return is generally a factor of quality of the issuing company, features of the share (callable, participating, etc.), and risk factors associated with bankruptcy.
Suppose dividends are Rs 50, Rs 75, and Rs 100 in the first 3 years and the required rate of returns is 7% per annum. The share can be valued at approximately Rs 194 in the following way:
Constant growth can be incorporated in the formula as well to find the perpetual value of a preference share. The formula can be:
D = Current Dividends
R = Required rate of Return
G = Constant Growth rate of Dividends
The price of a share in the live market is made up of three variables: Face value, Premium on the face value, and Accrued Dividend
Why should you buy a Preference Share?
- Regular income in the form of dividends
- Higher potential for returns as compared to bonds
- Lower risk as compared to common shares can be suitable for risk-averse investors
- Dividend income on preference shares is tax-free up to Rs 10,00,000 (pertaining to Indian tax laws)
How to purchase Preference Share in India?
Preference Shares can be purchased through the primary market (in case of an IPO or FPO) or through the secondary market (on the exchange or over the counter) depending on their listing status.
For online trading, investor must have a de-mat account.
The minimum amount of investment is Rs 10,00,000 in case of a private placement of preference shares.
For a public issue, the minimum amount can be as low as Rs 10.