Sunday, December 28

Preference Shares

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Preference shares, also known as preferred stocks can be said to be a mixture between debts and equity. The reason why they are known as preference shares as compared to ordinary shares, also known as common stock is because the preference shareholders are given preference over ordinary shareholders over some issues as given below.

1. Dividends
Dividends must be paid to the preference shareholders first before they can be paid to the ordinary shareholders.

2. Liquidation
In the event that the company is liquidated, the proceeds from the liquidation will be distributed to the preference shareholders first before it is being distributed to the ordinary shareholders. However, the depositors and the creditors of the company will be paid first before the preference shareholders.

3. Voting rights
In exchange for the above privileges, preference shareholders do not have any voting rights as compared with ordinary shareholders.

Unlike bonds or debts, the company issuing the preference shares has no obligations although it may have the right to purchase back or redeem the preference shares although it may have the right to redeem it back at a later period. Thus preference shares will not mature unless the company redeems it back.

The above mentioned features applies to all preference shares generally. There are some issues that separate different preference shares from one another.

1. Cumulative or non-cumulative
In the event that the company do not declare and pay any dividends for a particular financial year, the dividends that is supposed to be paid this financial year will be accumulated to the next financial year only if the preference shares are cumulative. If the preference shares are non-cumulative, the dividends that were not declared and not paid in the previous financial year will not be accumulated to the next financial year.

For example, you are holding 1 share of a OCBC cumulative preference shares that gives 5% dividend on a par value of $1000. For the year 2000, OCBC is supposed to pay you a dividend of 5% x $1000 = $50. However, OCBC decides not to give out the dividend for the year 2000. Now let's move on to the next year. For the year 2001, OCBC is supposed to pay you a dividend of 5% x $1000 = $50 again and OCBC decides to give out dividends for this year. However, remember that OCBC did not give out dividends in 2000. Since the shares are cumulative, they will have to pay out the dividends which they did not pay you in 2000 along with the dividends for 2001, thus you will receive a total of $100 in dividends. If the shares are non-cumulative, you will only receive a total of $50 since they will not have to pay you the dividends which they did not pay in 2000.

2. Convertibility
If the preference shares are convertible, it means that you can convert the preference shares to ordinary shares at a certain price. The advantage of this for investors is that you will be able to convert the preference shares to ordinary shares for a profit if the price of the ordinary shares are high.

I am touching on some other considerations on preference shares and perhaps a case study of a preference share issued by a local bank in another post. You can access it here.
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