Investing for Beginners: Pros and Cons of Preference Stocks

Preference shares have a number of benefits for companies and investors. The main benefit for shareholders is that preference shares have a fixed dividend. This must be paid before they can be paid to common shareholders.

While dividends are paid only if the company makes a profit, some types of preferred stocks, called cumulative shares, allow the accumulation of unpaid dividends. Once the business returns to a profitable situation, all unpaid dividends must be remitted to preference shareholders, before they can be paid to common shareholders.

In addition, in the event of winding-up and dissolution, preferred shareholders have greater credit over the company’s assets than ordinary shareholders. This makes preferred shares attractive to investors with low-risk tolerance. The company guarantees a dividend each year. However, if it doesn’t generate profit and should shut down, preferred shareholders are compensated for their earlier investments. Other types of preferred shares have additional benefits.

Advantages from the investor’s point of view

Convertible shares allow shareholders to trade their preference shares for a fixed number of common shares after a predetermined date. This can be a very lucrative option if the value of common stocks starts to rise.

Participating shares offer the shareholder the opportunity to enjoy additional dividends above the fixed-rate if the company meets certain predetermined profit goals.

Cumulative – shareholders of cumulative shares are entitled to claim dividend payments that have been missed in the past. The owed dividends must be paid to them before other classes of preferred stocks and common shareholders.

Non-cumulative – holders of such shares are not entitled to receive dividends in arrears. They receive dividends if there are enough profits. 

Perpetual – this is a type of preferred stock that pays a fixed dividend to the investor as long as the company is in business. They trade on stock exchanges like a common stock.

Callable preferred shares entitle companies to repurchase shares at their discretion. It means that if the callable shares are issued with a 6% dividend, but interest rates fall to 4%, the company may buy the outstanding shares at market price. They can then reissue them at a lower dividend rate, thereby reducing the cost of capital. Shareholders would consider this a disadvantage.

The main disadvantage of preference stocks

Preferred shareholders do not have the same ownership rights as common shareholders. So they cannot influence future plans, changes, twists or even bankruptcy prevention. They only reap the profits or losses resulting from the shareholders’ agreement.  

Furthermore, if interest rates rise, the fixed dividend that seemed so attractive may seem cheaper, as other fixed income securities emerge at higher rates.

From the company’s point of view

Issuing preference shares is also good for the company. The lack of shareholder voting rights is beneficial to the business. This is because it means that ownership is not diluted by selling preferred shares, as it happens with common shares.

Also, the cost of raising capital for the issuance of preferred shares is lower than for the issuance of common shares.

The corporation’s ability to suspend the dividends is its biggest advantage over bonds. It just requires a vote of the board and they run no risk of being sued for default.

In addition, companies can sell preferred stocks quicker than common stocks, because investors know they will be paid before other shareholders.

The main disadvantage from a company’s point of view

The higher cost of debt capital is the main disadvantage for companies. However, equity financing decreases the debt/equity ratio of the company, which is regarded by investors as a sign of a well-managed business.

Compared to other fixed-rate securities like bonds, the cost of increasing preferred share capital is generally higher. 

Other disadvantages include the dissolution of asset claims and high dividend rates.

Conclusion

The variety of preferred stocks and their significant benefits represent a relatively low-risk means to generate long-term income. If what you're looking to earn is extra passive income, preferred stocks can be a good opportunity for diversification in your portfolio - as well as an excellent entry into the equity market.

Preferred stocks can also make an attractive investment for those looking for a higher payout than they’d receive on bonds. However, they forgo the safety of bonds and the uncapped upside of common stocks.

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