What is the difference between preference shares and ordinary shares? What are the pros and cons of each type of share?

 

Understanding preference shares and ordinary shares: key differences, pros, and cons

  

When companies raise capital, they typically issue two main types of shares:  preference shares (also known as preferred stock) and ordinary shares (also called common stock). Each type of share represents ownership in a company, but they offer different benefits, risks, and rights to shareholders. This distinction is essential for investors looking to build a balanced and profitable portfolio.

1. Definition of preference shares and ordinary shares

Preference shares:  These shares provide shareholders with preferential treatment in certain areas, particularly in receiving dividends and during company liquidation. Preference shareholders usually receive fixed dividend payments before ordinary shareholders and have priority in asset distribution if the company faces bankruptcy. However, they often have limited or no voting rights in corporate governance.

Ordinary shares:  These shares represent standard ownership in a company and come with voting rights, typically one vote per share. Ordinary shareholders have a claim on the company’s profits, usually in the form of dividends, but they are paid out only after all obligations to preference shareholders are met. In the event of liquidation, ordinary shareholders are last in line to receive any remaining assets after creditors and preference shareholders.

2. Key differences between preference shares and ordinary shares

     The distinctions between preference shares and ordinary shares revolve around three main factors: dividends, voting rights, and risk.

a. Dividends

Preference shares:  Preference shareholders are entitled to a fixed dividend, regardless of the company's profit levels, and they are paid before ordinary shareholders. If a company does not pay dividends in a given year, some types of preference shares, known as "cumulative preference shares," allow dividends to accumulate and be paid in the future.

Ordinary shares:  The dividends for ordinary shares are variable and depend on the company’s profitability. If the company does well, ordinary shareholders might receive high dividends, but if profits are low or the company decides to reinvest earnings, they may not receive dividends at all.

b. Voting rights

Preference shares:  Preference shareholders typically have no voting rights, meaning they have little to no say in the corporate governance of the company, such as decisions on mergers or board appointments.

Ordinary shares:  Ordinary shareholders usually have full voting rights, giving them a say in major company decisions. The number of votes they have is proportional to the number of shares they hold.

c. Risk and claims on assets

Preference shares:  In the event of liquidation, preference shareholders have priority over ordinary shareholders in receiving the company’s remaining assets after debts have been paid. However, their claims come after those of bondholders and other creditors. While preference shares are generally considered safer than ordinary shares, they also offer lower potential for capital gains.

Ordinary shares:  Ordinary shareholders are the last to be paid in the event of liquidation, which makes ordinary shares riskier. However, they have a higher potential for capital appreciation and may benefit significantly if the company grows and profits increase.

3. Types of preference shares

     Preference shares come in various forms, offering different features to suit the needs of different investors.

Cumulative preference shares:  These shares accumulate unpaid dividends. If the company cannot pay dividends one year, it must pay them in the following years before any dividends are paid to ordinary shareholders.

Non-cumulative preference shares:  These do not accumulate unpaid dividends. If a dividend is missed, the shareholder cannot claim it later.

Convertible preference shares:  These can be converted into a fixed number of ordinary shares after a specified period, allowing investors to benefit from the company’s growth.

Redeemable preference shares:  The company has the option to repurchase these shares at a predetermined price after a certain date.

Participating preference shares:  These shareholders may receive additional dividends based on the company’s performance, on top of their fixed dividend.

4. Pros and cons of preference shares

Pros

Fixed income:  Preference shareholders receive a fixed dividend, providing a steady income stream, which can be appealing to income-focused investors.

Priority in liquidation:  Preference shareholders have a higher claim on the company’s assets in the event of liquidation, reducing their overall risk compared to ordinary shareholders.

Less volatility:  Preference shares tend to be less volatile than ordinary shares, making them more suitable for conservative investors.

Convertible options:  Convertible preference shares offer the opportunity to participate in the company’s growth by converting shares into ordinary stock.

Cons

Limited voting rights:  Most preference shares do not come with voting rights, meaning shareholders have little influence over corporate decisions.

Lower potential for capital appreciation:  Since preference shares do not typically rise in value like ordinary shares, they offer less opportunity for long-term capital gains.

Dividend risk:  Dividends are not guaranteed and depend on the company’s ability to pay. In the case of non-cumulative preference shares, missed dividends cannot be recovered.

Callable risk:  Some preference shares are callable, meaning the company can repurchase them at a fixed price, which could happen when market conditions are unfavorable for shareholders.

5. Pros and cons of ordinary shares

Pros

Voting rights:  Ordinary shareholders typically have voting rights, giving them influence over important corporate decisions, such as electing board members and approving major mergers or acquisitions.

Potential for high returns:  Ordinary shares offer higher potential returns through capital appreciation, particularly if the company performs well over the long term.

Dividend growth:  Though dividends are not fixed, many companies increase their dividend payments over time as profits grow, providing a growing income stream to shareholders.

Liquidity:  Ordinary shares are usually more liquid than preference shares, meaning they are easier to buy and sell on stock exchanges.

Cons

Riskier:  Ordinary shares are riskier than preference shares because they are the last to receive dividends and have the lowest claim on assets during liquidation.

No guaranteed dividends:  Ordinary shareholders receive dividends only after preference shareholders have been paid, and these dividends can fluctuate based on the company’s performance or be withheld altogether.

Market volatility:  Ordinary shares are more susceptible to price fluctuations, which can result in short-term volatility and uncertainty.

6. Which Type of Share is Best for Investors?

    Choosing between preference shares and ordinary shares depends on an investor’s financial goals, risk tolerance, and investment strategy.

Income-oriented investors:  Preference shares are ideal for those seeking stable income through regular dividends and a lower-risk profile. These shares are suitable for conservative investors, such as retirees, who prioritize income over growth and prefer stability.

Growth-oriented investors:  Ordinary shares are more suitable for those looking for long-term capital appreciation and are willing to accept higher risk. If an investor wants to participate in the company’s growth and benefit from price appreciation, ordinary shares are the better choice.

Balanced investors:  Some investors may prefer a mix of both types of shares. For example, holding preference shares for stability and ordinary shares for growth could provide a balanced approach to achieving both income and capital gains.

7. Conclusion

     Both preference shares and ordinary shares play vital roles in a company’s capital structure and offer unique benefits to different types of investors. Preference shares are ideal for those seeking fixed income and lower risk, while ordinary shares cater to investors looking for voting rights, capital appreciation, and potential dividend growth. Each investor must carefully consider their own financial goals and risk tolerance when deciding which type of share to include in their portfolio. A diversified approach that includes both types may provide the optimal balance between income, growth, and risk management.