Advantages and disadvantages of preferred shares
Which is better, investing in preferred stocks or ordinary stocks? What are the rights of preference shares? What happens to the shares if the company goes bankrupt? We will answer all of these questions below.
What are preferred shares?
Preference shares are shares established by the company with different characteristics. These characteristics vary depending on what the company decides. Before acquiring this type of asset, you must specifically know the particular features of preference shares.
These shares do not grant the shareholder the right to vote or share capital, but they prioritize when collecting dividends or settlements.
A preference share represents an ownership interest. It generally does not have a maturity date and is recognized on the equity side of a firm’s balance sheet.
Advantages of preference shares over ordinary shares
By investing in preference shares, the investor acquires a series of advantages or benefits that are not available to ordinary shareholders. Such advantages are political rights or the priority collection of dividends.
Priority in collecting dividends from preference shares
One of the main advantages of preference shares is that they usually have priority for the collection of dividends over ordinary shares. If all goes well for the company, both types of shares will receive their dividends. But if things are not going so well and the company cannot pay the total expected dividend, the preferred stock may collect its dividends, and the ordinary stock may be lower or may not charge at all. The dividend on preference shares can depend on several factors, including:
- The amount invested
- The evolution of the company’s results
- The dividend of ordinary shares
Preference shares have a higher income than the ordinary ones
Preferred shares don’t benefit from growth in dividends and capital value. A significant part of these equities’ interest has to be paid out in dividends initially. Because of this reason, preferred shares are better options for investing.
Valuation models
If the preference stock has a fixed dividend, we can calculate the value by discounting each of these payments. This fixed dividend is not guaranteed on ordinary shares. If we take these payments and calculate the sum of the current values in perpetuity, we will find the value of the shares.
For example, if company ABC pays a dividend of 25 cents each month and the required rate of return is 6% per year. Then, the expected value of the stock, using the dividend discount approach, would be $50. The discount rate was divided by 12 to get 0.005, but the annual dividend of $3 (0.25×12) could also be used and divided by the annual discount rate of 0.06 to get $50. In other words, you have to discount each dividend payment that is issued in the future and return to the present, and then add each value.
Growing dividends
If the dividend has a history of predictable growth, or the company claims that steady growth will occur, this needs to be considered. The calculation is known as the Gordon Growth Model.
By subtracting the growth number, the cash flows are discounted by a smaller number, resulting in a higher value.
In the event of bankruptcy, what would happen to the preference shares?
Another advantage that preference shares have is that in case of bankruptcy of the company, the shares Disadvantages of the preference shares have a collection preference over ordinary shares.
Disadvantages of preference shares versus ordinary shares
Just as there are advantages, the preference investor also has several disadvantages concerning ordinary shareholders.
Preference stock liquidity
preference shares are less liquid than ordinary shares, mainly for three reasons:
- Fewer preference shares are outstanding than common shares.
- The shareholders are usually institutional investors.
- The owners of the preference shares are typically long-term investors.
Political rights of preference shares
One of the main drawbacks of preference shares is that investments in preference interests are excluded from voting rights.
Typically, in preference shares, the shareholder does not have any political right. That is, they cannot vote at shareholders’ meetings. This may not matter for a small investor, but many investors prefer to have the ability to influence the decisions of the company. It applies to people who own large amounts of shares. This could be because the company launches a takeover bid, or there are fights for control of the company. In a venture between investors, these voting rights have a lot of meaning and make the shares with these voting rights worth more than those that do not.
However, it would help if you continued to take this into account when evaluating the marketability of preferred stocks.
Preference shares are redeemable
In many cases, preference shares are redeemable by the decision of the company. The fact that they are redeemable means that the company can buy the preference shares whenever it wants, at the same price at which they were sold.
Difference between ordinary Shares and Preference Shares
The difference between ordinary and preferred shares has its connection with legality, advantages, and powers. In this sense, these are the differences of considerable significance:
- The commitment and restricted obligations govern the common shareholder.
- Preferred stockholders gravitate between organizational diplomacy and extended-time returns.
- For ordinary shareholders, returns in small profit periods are better.
- When there are assets to be settled, the first to benefit are the preferred shareholders and then the owners of the ordinary shares.
- Given the opportunity to increase the shares in the organization, the owner of the preference Shares enjoys the offer at lower costs.
The choice between ordinary shares or preference shares
Suppose you have to choose between a company that has ordinary shares or preference shares. In that case, common shares are usually more attractive due to political rights and because they are not redeemable. Although the preferred ones have different characteristics, there may be cases where the preference shares are more interesting than the ordinary ones. Preference stock is less volatile than the common one, which may be an attractive feature for the right investor. Bear in mind that these types of shares also have less profit potential.
However, of course, you should always study all the legal implications of acquiring any equities.
