What are Preferred Shares?

A Company issues two types or classes of shares – Common and Preferred. Common or Equity share represents ownership in a Company. Holders of Common shares may or may not be entitled to the dividend, depending upon the company’s profitability. On the other hand, a preference share entitles its holders to a fixed dividend irrespective of the company’s profitability. Dividends received on the preferred stock are known as preferred dividends. They are preferred because if a company cannot pay all dividends, claims to preferred dividends will precede claims to dividends paid on equity shares.

Preferred Share Dividends Calculation

Let’s understand the calculation of preferred dividend with the help of illustration

Mr. X owns 20,000 10 percent preferred shares, which were issued at a par value of $50 per share. Currently, the stock is trading on NYSE at $60 then:

Preferred Dividend Calculation

The dividend per share of preferred shares = $50 * 10% = $5

Total Preferred Dividends = 10,000 shares * $50 * 6.5% = $32,500

To calculate the preferred dividendCalculate The Preferred DividendPreferred dividends refer to the amount of dividends payable on preferred stock from profits earned by the company, and preferred stockholders have priority in receiving such dividends over common stockholders.read more, multiply the preferred shares’ par value or issue value by the dividend percentage. The dividend percentage is stated in the prospectus. Alternatively, the percentage is also stated in the share certificate issued by the company.

Preferred Dividend Yield Calculation

Dividend yield ratioDividend Yield RatioDividend yield ratio is the ratio of a company’s current dividend to its current share price.  It represents the potential return on investment for a given stock.read more = 5/60* 100% = 8.33%

Yield is the effective interest rateEffective Interest RateEffective Interest Rate, also called Annual Equivalent Rate, is the actual rate of interest that a person pays or earns on a financial instrument by considering the compounding interest over a given period.read more a person receives if he holds the share for one year. The formula for calculation of dividend yield ratio is,

Dividend per Share / Market Price per Share * 100%

Top 6 Types of Preferred Shares

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#1 – Cumulative Preference Shares

In cumulative preferred shares, the preferred dividend accumulates for subsequent years. Such type includes the provision wherein the company is required to pay all dividends – Present and past- in subsequent years.

source: Hanesbrands Inc

#2 – Non-Cumulative Preference shares

In the case of non-cumulative preferred shares, the company has no legal obligation to pay past accumulated dividends. If a company does not pay dividends on business necessity or otherwise, shareholders have no right to claim unpaid dividends in the future.

source: businesswire.com

#3 – Convertible Preference shares

This type of share gives its holders a legal right but not an obligation to exchange for a predetermined number of a company’s equity or common stock. It allows the holder to participate in the equity shares by conversion. Conversion may occur at a predetermined time or any time the investor chooses. Conversion occurs at an exercise priceExercise PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.read more, which is always a predetermined price.

source: Yelp

#4 – Participating Preference shares

The company pays additional dividends on achieving certain predetermined milestones like achieving certain amounts of revenue, net profit, or some other benchmarks. It allows shareholders to receive additional dividends apart from normal regular dividends. Shareholders continue to receive their regular dividend regardless of a company achieving a predetermined milestone.

source: Autodesk

#5 – Perpetual Preference shares

These types do not have any maturity period. In the case of perpetual preferred shares, the initial invested capital is never returned to the shareholders. Shareholders continue to receive a preferred dividend for an infinite period. Most of the preferred shares fall into this category.

source: General Finance

#6 – Prior Preference shares

The company generally issues more than one type, i.e., they may issue convertible, non-convertible, participating, etc. Any preferred share, designated as prior preferred stock by the company, will have a prior claim on dividends over other types of preference stock. Therefore, it can be said that prior preferred stocks have less credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower’s failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt’s principal and an interest component, resulting in interrupted cash flow and increased cost of collection.read more than other preferred stocks. Let’s understand this with the help of a simple illustration.

Company X Inc. has the following outstanding preference shares.

6% Series X perpetual preferred shares – 5 mn

6% Series Z Prior preferred shares – 5 mn

Available cash 300,000

In the above case, the dividend will be paid as follows.

Dividend to be paid on Series x = $300,000 (5mn * 6%)

Dividend to be paid on Series z = $300,000 (5mn * 6%)

Total dividend to be paid = $600,000

Available cash = $300,000

In the above case, there is a shortage of available cash to pay the total dividend liability. Hence only a dividend of up to $300,000 will be paid to the shareholders. Payment will not be distributed amongst series x and z proportionately. But the entire payment will be made to series Z, prior preference shares, since such shares will always have a prior claim on dividends over other types of shares.

The above list comprises most of the types issued by the company in the primary and secondary marketsSecondary MarketsA secondary market is a platform where investors can easily buy or sell securities once issued by the original issuer, be it a bank, corporation, or government entity. Also referred to as an aftermarket, it allows investors to trade securities freely without interference from those who issue them.read more.

Is Preferred Share equity or debt?

Preferred shares are hybrid securityHybrid SecurityHybrid securities are the combined characteristics of two or more types of securities, usually both debt and equity components. These securities allow companies and banks to borrow money from investors and facilitate a different mechanism from the bonds or stock offering.read more sharing some features of a debt instrument and some of the equity.

Equity features

Like equity, it has a perpetual life, i.e., infinite life. The financial statementThe Financial StatementFinancial statements are written reports prepared by a company’s management to present the company’s financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more is shown under the shareholder equity section, not the debt column. While interest payments on debt are tax-deductible, preferred dividends are not tax-deductible.

Debt features

Like debt, preference shares have a fixed dividend payout as stock carries a fixed dividend rate. Investing in such shares is more like investing in a debt instrumentDebt InstrumentDebt instruments provide finance for the company’s growth, investments, and future planning and agree to repay the same within the stipulated time. Long-term instruments include debentures, bonds, GDRs from foreign investors. Short-term instruments include working capital loans, short-term loans.read more than equity since almost all the returns come from dividends.

  • As can be seen from the above-stated facts, such shares exhibit the features of both equity and debt. Hence the classification of preference shares under debt or equity would depend upon the type and nature of preferred stock.Perpetual and cumulative preferred stockCumulative Preferred StockCumulative preferred stock is a class of shares wherein any current year’s unpaid or undeclared dividends must be accumulated and paid in the future. However, such stocks are costlier, do not have voting rights and cannot demand the interim dividends.read more can easily be classified as debt instruments. The dividends received from them are fixed, and invested capital never gets refunded because of their infinite period.Whereas non-cumulative and convertible preference shares are classified as equity;Hence, it can be said that the type of preferred shares plays an important role in its classification.

Users of Preferred Shares

  • The cost of preference share is more than the cost of debt but less than the equityCost Of EquityCost of equity is the percentage of returns payable by the company to its equity shareholders on their holdings. It is a parameter for the investors to decide whether an investment is rewarding or not; else, they may shift to other opportunities with higher returns.read more instrument. The reason is simple; the cost depends upon the riskiness associated with the instrument.Amongst the three instruments mentioned above, the financial risk in holding an equity stock is far greater due to the tax advantagesTax AdvantagesTax Advantage are the types of investments or saving plans that benefit tax exemption, deferred tax, and other tax benefits. Examples include Government bonds, Annuities, Retirement Plans. read more of interest payments and uncertainties associated with its dividend payment.On the other hand, the cost of preference is greater than the cost of debtCost Of DebtCost of debt is the expected rate of return for the debt holder and is usually calculated as the effective interest rate applicable to a firms liability. It is an integral part of the discounted valuation analysis which calculates the present value of a firm by discounting future cash flows by the expected rate of return to its equity and debt holders.read more on account of the tax advantages of interest payments.Despite being costlier than the debt, it is preferred by many companies to raise additional capital.Among US companies, the biggest issuers of preferred shares are the financial service companies (banks, insurance companies), and there is a simple reason for it.While it may be more expensive than conventional debt, it is counted as equity by the regulatory authorities while computing capital ratios for banks.

Conclusion

Over the years, preferred shares have become quite a popular instrument used by corporations for raising capital. Preferred shares combine features of both types of an instrument – Debt and Equity. However, preferred dividend payment depends upon several factors, such as the availability of cash and the company’s profitability. But the shareholder’s right to receive is absolute and is not affected by the above factors. In case of a shortage of funds, it is paid later. All these factors have contributed to its growing popularity over the other forms of investments.

What are Preferred Shares – Debt or Equity? Video

  • Cost of Preferred StockCost Of Preferred StockA preferred share is a share that enjoys priority in receiving dividends compared to common stock. The dividend rate can be fixed or floating depending upon the terms of the issue. Also, preferred stockholders generally do not enjoy voting rights. However, their claims are discharged before the shares of common stockholders at the time of liquidation.read moreEarnings Per Share (EPS)Earnings Per Share (EPS)Earnings Per Share (EPS) is a key financial metric that investors use to assess a company’s performance and profitability before investing. It is calculated by dividing total earnings or total net income by the total number of outstanding shares. The higher the earnings per share (EPS), the more profitable the company is.read moreWhat is Accelerated Share BuybacksWhat Is Accelerated Share BuybacksAccelerated share repurchase (buyback) is a strategy adopted by a publicly-traded company to acquire its outstanding shares in the market from the clients in large blocks via an investment bank.read moreTreasury Stock Method CalculationTreasury Stock Method CalculationTreasury Stock Method is an accounting approach assuming that the options & stock warrants are exercised at the beginning of the year (or date of issue, if later) & proceeds from the exercise of these options & warrants are used to repurchase shares in the market. read more