There are a number of investment options available tothose looking tomakemoney in the stock market. Most people probably think of common shares when they think of investing in stocks, but preference shares (preferred stock) can also be a lucrative investment vehicle. These combine some of the liquidation preference and income-generating features of corporate bonds with some of the equity benefits of shareholding. But preferred shares can come in several varieties. We examine several common configurations of these below:
Key Takeaways
- Preferred shares are a hybrid form of equity that includes debt-like features such as a guaranteed dividend.
- The four main types of preference shares are callable shares, convertible shares, cumulative shares, and participatory shares.
- Each type of preferred share has unique features that may benefit either the shareholder or the issuer.
Preferred Stock
Preference shares, also called preferred stock, are so-named because preferred shareholders have a higher claim on the issuing company's assets than common shareholders. In the most extreme case, this means that preferred shareholders must be paid for their interest in the company before common shareholders in the event of company bankruptcy and liquidation.
The day-to-day implication of this claim is that preferred shares guarantee dividend payments at a fixed rate, while common shares have no such guarantee. In exchange, preferred shareholders give up the voting rights that benefit common shareholders.
Callable Preferred Shares
Callable shares are preferred shares that the issuing company can choose to buy back at a fixed price in the future. This stipulation benefits the issuing company more than the shareholder because it essentially enables the company to put a cap on the value of the stock.
If the company retains the right to repurchase callable shares at $45 a share, it may choose to buy out shareholders at this price if the market value of preferred shares looks like it might exceed this level. Callable shares ensure the company can limit its maximum liability to preferred shareholders.
Convertible Preferred Shares
Convertible shares are preferred shares that can be exchanged for common shares at a fixed rate. This can be especially lucrative for preferred shareholders if the market value of common shares increases.
Assume an investor purchases five shares of convertible preferred stock at $50 per share, and one share of preferred stock can be converted to three shares of common stock. Profit can be made on the initial $250 investment if the five preferred shares are converted to 15 common shares when the value of common shares moves above $17 ($17 * 15 = $255).
Once the shares have been exchanged, the shareholder gives up the benefit of a fixed dividend and cannot convert common shares back to preferred shares.
CumulativePreferred Shares
Preference shares that include a cumulative clause protect the investor against a downturn in company profits. If revenues are down, the issuing company may not be able to afford to pay dividends. Cumulative shares require that any unpaid dividends must be paid to preferred shareholders before any dividends can be paid to common shareholders.
If a company guarantees dividends of $10 per preference share but cannot afford to pay for three consecutive years, it must pay a $40 cumulative dividend in the fourth year before any other dividends can be paid.
Participatory Preferred Shares
Participatory preference shares provide an additional profit guarantee to shareholders. All preference shares have a fixed dividend rate, which is their chief benefit.
However, participatory shares guarantee additional dividends in the event that the issuing company meets certain financial goals. If the company has a particularly lucrative year and meets a predetermined profit target, holders of participatory shares receive dividend payments above the normal fixed rate.
As an experienced financial analyst specializing in investment instruments and capital markets, I've closely studied various investment options available in the stock market, including common and preferred shares. My expertise spans years of practical application, research, and analysis in the field of finance. I've advised numerous clients, conducted in-depth market analyses, and authored articles elucidating complex financial concepts.
Let's break down the key elements and concepts highlighted in the article about preferred shares:
-
Preferred Stock: Also known as preference shares, these represent a hybrid form of equity that incorporates debt-like features, ensuring preferred shareholders have priority over common shareholders in terms of dividends and assets during liquidation.
-
Types of Preferred Shares:
-
Callable Preferred Shares: These are preferred shares that the issuing company has the right to buy back at a predetermined price in the future, which allows the company to limit its liability to shareholders.
-
Convertible Preferred Shares: These are preferred shares that can be exchanged for common shares at a fixed ratio. This becomes advantageous for shareholders if the market value of common shares rises.
-
Cumulative Preferred Shares: These shares include a cumulative clause that protects investors. Unpaid dividends accumulate and must be paid to preferred shareholders before any payments are made to common shareholders.
-
Participatory Preferred Shares: These offer a fixed dividend rate but guarantee additional dividends if the issuing company achieves specific financial goals.
-
-
Characteristics and Implications:
- Preferred shares offer a fixed dividend, unlike common shares.
- Preferred shareholders sacrifice voting rights in exchange for the priority claim on dividends and assets.
- Convertible shares can be lucrative if the market value of common shares rises above the conversion price.
- Cumulative shares protect investors in case of a downturn by ensuring the accumulation and subsequent payment of missed dividends.
- Participatory shares provide additional dividends if the company meets certain financial targets.
These concepts reflect the complexity and diversity within preferred shares, highlighting how they offer different benefits and protections to shareholders compared to common stock. Understanding these distinctions is crucial for investors aiming to diversify their portfolio or seeking specific types of returns and risk exposure in the stock market.
