Preference Shares: Advantages and Disadvantages

Preference shares, also known as preferred stocks, are a type of equity that offers investors a unique set of benefits and risks. These shares provide a fixed dividend rate, priority in dividend payments and asset claims, and are generally less volatile than common stocks. However, they also come with limitations such as the lack of voting rights and potential for lower growth potential. In this article, we will delve into the advantages and disadvantages of investing in preference shares, providing a comprehensive overview for investors.

Advantages of Preference Shares

• Fixed Dividend Payments: One of the primary advantages of preference shares is the fixed dividend rate. This means that investors receive a stable and predictable income, regardless of the company's performance. For example, if a company issues preferred stock with a 6% dividend rate, investors will receive 6% of the par value each year, providing a secure source of income.
• Priority in Dividend Payments and Asset Claims: Preference shareholders have priority over common shareholders in receiving dividends and in the event of liquidation. This ensures that they receive a portion of the capital or dividends first, making them a safer investment option.
• Lower Financial Obligation for Companies: Companies issuing non-cumulative preference shares do not have to accumulate unpaid dividends, reducing their financial burden. This flexibility is particularly helpful in years of low profitability, enabling companies to manage their cash flow effectively.
• Appealing to Risk-Tolerant Investors: Preference shares are appealing to investors who are willing to accept a higher level of risk in exchange for regular dividends when the company is profitable. The possibility of forfeiting dividends in lean years is offset by potential returns in good years.
• Reduced Dividend Liability: Companies issuing non-cumulative preference shares do not have the liability of future unpaid dividends. This makes it easier to manage their long-term dividend obligations and allows for more efficient financial planning.

Disadvantages of Preference Shares

• Higher Risk for Investors: Since unpaid dividends are not carried forward, investors face the risk of losing dividend income in unprofitable years. This lack of guarantee makes these shares less appealing to risk-averse investors seeking stable returns.
• Lower Investment Security: Non-cumulative preference shares provide less security than cumulative shares, as investors are entirely dependent on the company's ability to declare dividends each year. If dividends are not declared, investors receive no compensation.
• Less Attractive for Conservative Investors: For conservative investors who prioritize guaranteed returns, non-cumulative preference shares may not be a preferred choice. The uncertainty surrounding dividend payments reduces their attractiveness compared to cumulative preference shares, which provide more reliable income.
• Limited Growth Potential: Preference shares generally have limited growth potential, as they do not offer participation in surplus profits or residual value. This makes them less suitable for investors seeking high returns tied to company performance. This is unlike the stock market where returns can be higher.
• Limited Voting Rights: Unlike common stocks, preference shares typically do not come with voting rights. This means that investors have limited influence over company decisions, which may be a drawback for those who value active participation in corporate governance.

Conclusion

Preference shares offer a unique set of advantages and disadvantages that make them an attractive option for certain types of investors. The fixed dividend rate and priority in dividend payments and asset claims provide a stable source of income and ensure that investors are protected in the event of company liquidation. However, the lack of voting rights and potential for lower growth potential may deter some investors. Ultimately, the decision to invest in preference shares should be based on an individual's risk tolerance, investment goals, and the specific characteristics of the preferred stock being considered.