What is Preference Share?
A preference share or preferred equity is similar to a company’s ordinary share in terms of ownership. However, preferred equity does not carry voting rights.
In terms of seniority of company instruments, preference shares rank above equity shares but below company bonds. But a company cannot issue only preference shares without issuing common shares.
Preference shares are suitable for investors who want a stable source of income without risking the volatility of ordinary shares. Preferred stockholders also forgo the upside potential of common stock because preferred stock does not change significantly in value over any given holding period.
In case of bankruptcy, preference shares will be issued before ordinary shareholders. Interestingly, the preference shareholders are paid a fixed dividend on the par value of the preference share. The par value of a share is the value of the share as stated in the company’s charter and is usually less than the actual fair value of the preferred equity.
A preference share is an equity instrument but also has features of a debt instrument such as fixed payment of dividend and callability. Hence, preference shares straddle the blurred line between debt and equity and are generally considered hybrids
For example, a 5% preference share with a face value of Rs. 100 will pay Rs. 5 per annum as dividend. The shares will trade at a discount if the required market rate of return on the same preference shares exceeds 5%, resulting in a capital loss to an investor who purchases the shares at face value in the initial offering. Shares will trade at a premium to their face value if the required market rate of return is less than 5%.
- Unlike common shares, preference shares are not volatile and are suitable for sale to institutional investors during an IPO. Investors in preferred equity are also subject to favorable tax provisions on dividends earned.
- Unlike the timely payment of interest on bonds issued by the company, dividends on preference shares can be paid depending on the cash position of the company. A company can pay a lump sum dividend whenever they feel comfortable. On the other hand, non-payment of interest for bond issues reduces the company’s credit standing.
What are the types of preference shares?
- Cumulative preference shares: The most common form of preferred equity where dividends, if unpaid, are considered outstanding and take priority over other dividend payments. In other words, if the company does not have the capacity to meet its obligations to pay dividends to its shareholders, cumulative dividends may be paid as arrears in later years. The law prohibits the company from paying any dividend to the common shareholders unless the preference shareholders receive dividends. Preference shares may be cumulative or non-cumulative
- Non-Cumulative Preference Shares: Shareholders in this category are not compensated for unpaid dividends, unlike Cumulative Preference Shares. For example, if a company skips a dividend payment after it has declared it, the company is under no obligation to follow through on the earlier announcement of paying the dividend.
- Redeemable Preference Shares: The company issues redeemable preference shares at a later stage. Simply put, a company may opt for a buy-back in the future
- Irrevocable Preference Shares: Shares in this category can be redeemed if the company ceases its operations or liquidates itself.
- Adjustable-Rate Preference Shares: There is no provision for fixed dividend rate under this category, the dividend payment depends on the interest rates prevailing in the market
- Callable Preference Shares: Being a hybrid security, the issuing company is given the right to redeem the shares on a specific date and at a price specified at the time of issue. This feature makes preferred equity less attractive to investors
- Convertible Preference Shares: Shares are convertible into common equity at a specific time and price; Considered to be the most versatile and attractive form of preferred equity with diversified risk exposure
- Non-Convertible Preference Shares: Shareholders owning non-convertible preference shares, do not have the right to convert them into common equity.
- Participating Preference Shares: Another common classification for preference equity, where if the shares participate, they have the opportunity to earn more than the state rate of fixed dividends. Dividends on participating preference shares are higher if the company earns more than a specified benchmark. Earnings
- Non-Participating Preference Shares: Shareholders in this category cannot be paid dividends out of excess profits and enjoy only a fixed rate of dividend.
Is preference share debt or equity?
Preference shares have similar characteristics to debt and equity, in that they pay dividends like bonds and carry equity risk as the principal amount is not secured.
Can preference shares qualify for buy-back?
Like common equity, preference shares are also redeemable. Preference shares do not require redemption at maturity as they are eligible for buy-back like equity shares.
Can preference shares be issued at a premium?
Yes, preference shares can be issued at a premium.
What are the terms and guidelines for issuing preference shares?
- As per Section 55 of the Companies Act, only redeemable shares can be issued by a company. The Companies Act prohibits a company from issuing non-convertible preference shares
- Preference shares must be compulsorily redeemed by the issuing company within a period of 20 years from the date of issue. There is a provision where the redemption period may extend beyond 20 years, however, in this case, the shareholder must have the option to partially redeem his preference shares every year.
- To adopt the private placement route for issuing securities, the issuing company is required by law to send an offer letter to the persons to whom the shares of the company are being issued.
What are the conditions for redemption of preference share?
- Only fully paid-up preference shares are allowed to be redeemed
- Redemption of preference shares is permitted only from:
- Profits available for distribution to shareholders
- Equity/preference shares are issued only for the purpose of redemption of preference shares
- If the company wants to redeem the preference shares from the fresh proceeds of the newly issued preference shares, at least 75% of the shareholders must provide consent to carry out this action with the approval of the Tribunal.
- Once the consent of the existing shareholders is granted and necessary approvals are sought from the Tribunal, the shareholders who initially opposed the issue of new preference shares for the purpose of redeeming the existing preference shares will have their shares redeemed on an immediate basis. Orders of the Tribunal.
- Moreover, preference shares issued to redeem old preference shares cannot be added to the existing share capital of the company.
What are the Similarities Between Preference Shares and Bonds?
- Interest rate sensitivity : Like any other fixed-income instrument, preference share is also sensitive to interest rates. If the market pays more interest than the rate of dividend, the market value of the preference share falls
- Callability: Preference shares are callable from the issuer, which is essentially redemption of shares, at a specified price and time. It happens when a company has to pay a dividend higher than the prevailing interest rate on the shares
- Seniority: Bonds and preference shares are senior instruments in that they rank higher than ordinary shares. In the event of bankruptcy, the amount due on the senior securities is serviced first.
- Credit Rating: Like bonds, preference shares also have a credit rating issued by credit rating agencies such as Moody’s depending on the company’s quality and dividend payments.
What is the difference between preference shares and bonds?
- Classification: Bonds are classified as debt and preference shares as equity
- Payment of Dividends: Dividends are fixed but not guaranteed, unlike interest on bonds which must be paid according to the loan schedule
- Marketability: Preference shares are more liquid as they trade on stock exchanges. Bonds are generally over-the-market securities with a negligible presence on exchanges.
What are the Similarities Between Preference Shares and Equity Shares?
- Classification: Preference shares are classified as equity and are similar to the common equity offered by the company. Like any other equity instrument, preference shares are paid out of profit after tax but preference shares have a fixed rate of dividend.
What is the difference between preference shares and equity shares?
- Voting rights: Ordinary equity has voting rights which preference equity does not have
- Payments: Ordinary shares are not eligible for fixed dividends, the company may or may not declare dividends to ordinary shareholders. However, preferred equity attracts cumulative or non-cumulative dividends. In the event of bankruptcy, preferred shareholders make their claims before common shareholders.
- Volatility: Preferred equity has no appeal when prices rise. Common stocks actively react to market developments on a daily basis. Preferred equity is very fundamental in nature and follows constant price movements and hence gives moderate returns.
How is value of preference shares determined?
Common shares are valued based on future earnings per share. Similarly, preferred equity is entitled to dividends and can be valued at the sum of the present value of future dividends per share.
If dividends can be predicted accurately, they can be discounted to their present value using the required rate of return on preferred equity. The required rate of return is generally a factor of the quality of the issuing company, the characteristics of the share (callable, participating, etc.), and the risk factors associated with bankruptcy.
Suppose the dividends are Rs 50, Rs 75, and Rs 100 in the first 3 years and the required rate of return is 7% per annum. A share can be valued at approximately Rs 194 as follows:
Constant growth can be included in the formula to find the perpetual value of a preference share. The formula can be:
where,
D = Current Dividend
R = required rate of return
G = constant growth rate of dividend
The share price in the live market is composed of three variables: face value, premium over face value, and accrued dividends.
The returns on preference shares are similar to bonds. Returns consist of 2 components: 1. Dividend and 2. Market value or share price. For example, if you spend Rs. 100 if a 5% preference share of face value is purchased, currently Rs. 100, your returns for a holding period of 1 year will be as follows:
In the event that after 1 year the market price of the preference share is Rs. 110, then
dividend yield = Rs. 5
Capital gain = Rs. 10
returns 1 year holding period = (10+5) / 100 = 15%
Why Should You Buy Preference Shares?
- Regular income in the form of dividends
- Higher potential of return compared to bonds
- Lower risk compared to common stocks may be suitable for risk-averse investors
- Dividend income on preference shares is tax free upto Rs 10,00,000 (as per Indian tax laws)
How to buy preference shares in India?
Preference shares can be purchased through the primary market (in case of IPO or FPO) or through the secondary market (on an exchange or over the counter) depending on their listing status.
For online trading, investors must have a demat account.
In case of private placement of preference shares the minimum investment amount is Rs 10,00,000.
For a public issue, the minimum amount can be as low as Rs.10.