How do preferred shares work and what’s the difference?
Preferred shares and common shares have a lot of similarities. However, there are some critical differences. Most investors today own common shares, which are the equities that investors buy and sell on a daily basis. The other, as its name suggests, seems to be for an exclusive class.
So, what is a preferred stock? How do they work, and what even makes them different from common stock? Let’s dive in.
What are preferred shares, and why are they preferred?
Preferred shares are also called preference shares. Like common stock, they are a type of securities that are a representation of ownership in a business. In other words, it’s another form of equity and contributes to the total number of shares outstanding.
However, the key difference is that a preferred share has a priority claim over the company’s assets and earnings over standard shares. Therefore, if a business were to go insolvent, preferred shareholders would get liquidation preference over ordinary shareholders. But it’s important to note that a preferred stockholder has a lower priority over junior debt holders.
That certainly sounds ideal. So why don’t more people own them? There are a few reasons. Firstly, a company may not even issue preferred stock. And the ones that do tend to only offer them to a select group of investors. Furthermore, preferred stock rarely have any voting rights. And the ones that do tend to be extremely limited to prevent the risk of a hostile takeover.
When it comes to dividends, preferred shares once again have priority of payment over ordinary shareholders. But a limitation to this is that dividends are fixed. In other words, even if the company raises the quarterly or annual dividend payment for ordinary shareholders, a preferred shareholder still receives the same amount. This makes preferred stock a similar source of fixed income as bonds with a static interest rate.
Another unique feature of this class of shares is its ability to mature. Upon maturity, the company returns the money to the investors. Even if the market price has fallen lower than the original issue price. It’s also worth noting that convertible preferred stock offer investors the ability to transform their investment into common stock at the time of maturity.
Why do companies issue preference shares?
Issuing preferred shares is another method of raising capital through equity without losing voting power. It also doesn’t compromise the debt-to-equity ratio of the stock, potentially making it more desirable for investors to buy.
In practice, these shares behave very similarly to debt. Yet the lack of interest payments makes them more desirable to house them on the balance sheet. But it’s worth noting that, unlike debt, preferred shares are not tax-deductible. Therefore taking on debt can often be a more financially viable capital raising strategy for businesses.
Difference between preferred shares and common stocks
I’ve already mentioned a few differences, but here is a summarised list
- Preferred stocks have priority over common stocks when it comes to a corporation’s earnings.
- Common shareholders have voting rights, and preferred stockholders do not or have limited voting rights.
- Preference shareholders typically enjoy higher and more reliable dividends, but these payments are fixed. Whereas a common share can see more volatility in dividend payments but have the potential to benefit from long-term growth.
What are the pros and cons of preferred stocks?
Let’s take a look at the main advantages and disadvantages of these preferred securities.
Advantages of prefered shares
- They have regular dividends.
- Have a lower risk of capital loss
- Have the right to a preferred dividend that has priority over common stockholders.
- Some preferred stocks can be converted to common shares upon maturity.
Disadvantages of preferred shares
- Have low capital gain potential.
- Their right to dividend comes only if funds remain after interest has been paid to bondholders.
- Have few voting rights, in many cases, no voting rights at all.
Should I add preferred stocks to my portfolio?
Preference shares are attractive to the holder as they typically offer higher (but fixed) and more consistent dividends. That notwithstanding, they are not so attractive to investors seeking capital growth. Whether or not these types of shares belong in a portfolio is dependent on an investor’s financial goals.
Typically for long-term investors seeking to grow their wealth, common stock is arguably the better route to take. However, there’s no reason why an investor can’t buy both and diversify.
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Prosper Ambaka does not own shares in any of the companies mentioned. The Money Cog has no position in any of the companies mentioned. Views expressed on the companies and assets mentioned in this article are those of the writer and therefore may differ from the opinions of analysts in The Money Cog Premium services.