Preference Shares: Description and Types

With a name like preference or preferred it has to be good, right? Well, maybe. It depends on your goals and objectives. __Preference shares__, also known as __preferred stock__, are hybrid securities with characteristics of both debt and common equity. This type of stock is like debt since the main reason for owning it is usually due to the income you receive: interest payments in the case of bonds, and dividends in the case of preference shares. It is also like equity, since it is listed in the equity portion of the balance sheet and usually has a perpetual maturity date. The equity nature of the investment also implies that a missed dividend payment cannot force the firm into bankruptcy.

Suppose a firm generates cash flow and this cash flow is distributed to its security holders, debt, preferred equity, and common equity. In which order do you think preference shareholders are paid, given these three classes of security holders?

Incorrect. Bondholders are paid in full first by the firm, before payment to other security holders is considered.

Correct! Preference shareholders are paid second. They receive payment after bondholders are paid in full, but before common shareholders are paid.

Incorrect. Common stockholders are paid last. In return for lesser payment priority, common stockholders have the highest upside return potential.

There are several types of preference shares. __Cumulative preference shares__ require that any missed dividend payments be paid in full before any common dividends can be paid. __Non-cumulative preference shares__ have no such provision. __Participating preference shares__ allow for the possibility of receiving _additional_ dividends if the company's profits exceed a certain level. __Non-participating preference shares__ have no such provision. Lastly, __convertible preference shares__ entitle preference shareholders to convert their shares into a prespecified number of common shares.

Which type of preference shares do you think _most likely_ has the best upside potential in the long term, if the underlying company consistently delivers sales and profits ahead of consensus expectations?

Incorrect. Certainly, in this case, cumulative preference shareholders would receive all of their promised dividend payments, but upside potential beyond these dividends remains limited.

Incorrect. Although participating preference shares would likely have done well in this case, by receiving extra dividends over time, the upside potential is greater for common shares.

Correct! In this case, the best performance is likely achieved by converting the preference shares into common shares. Common shares have the most upside potential if a company does well. Imagine owning stock in Apple or Google ten years ago!

In summary: [[summary]]

First

Second

Third

Cumulative preference shares

Participating preference shares

Convertible preference shares

Continue

Continue

Continue

Continue