As someone who has spent years navigating the complexities of corporate finance, I understand how intimidating preferred and ordinary shares can be for beginners. Investors often hear these terms thrown around, but few grasp their nuances. In this guide, I break down preferred ordinary shares—what they are, how they differ from common stock, and why they matter in an investment portfolio.
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What Are Preferred Ordinary Shares?
Preferred ordinary shares, often just called “preferred shares,” are a hybrid security that blends features of both equity and debt. Unlike common stock, which represents direct ownership in a company, preferred shares come with fixed dividends and priority in payouts. However, they lack voting rights, which common shareholders typically enjoy.
Key Characteristics of Preferred Shares
- Fixed Dividends – Preferred shareholders receive dividends before common shareholders. The dividend rate is usually fixed, making them similar to bonds.
- Priority in Liquidation – If a company goes bankrupt, preferred shareholders get paid before common shareholders (but after debt holders).
- No Voting Rights – Unlike common stock, preferred shares usually don’t grant voting power in corporate decisions.
- Convertible Options – Some preferred shares can be converted into common stock at a predetermined ratio.
Preferred vs. Ordinary Shares: A Side-by-Side Comparison
To better understand the differences, let’s compare preferred and ordinary shares:
| Feature | Preferred Shares | Ordinary Shares |
|---|---|---|
| Dividends | Fixed, paid first | Variable, paid last |
| Voting Rights | Usually none | Yes |
| Liquidation Order | Before common, after debt | Last in line |
| Price Volatility | Lower | Higher |
| Conversion Rights | Sometimes convertible | No conversion option |
The Mathematics Behind Preferred Shares
Investors often evaluate preferred shares based on yield and present value. Let’s explore some key calculations.
Calculating Dividend Yield
The dividend yield for preferred shares is straightforward:
Dividend\ Yield = \left( \frac{Annual\ Dividend}{Current\ Market\ Price} \right) \times 100Example: If a preferred share pays an annual dividend of \$5 and trades at \$100, the yield is:
Dividend\ Yield = \left( \frac{5}{100} \right) \times 100 = 5\%Present Value of Preferred Shares
Since preferred shares pay fixed dividends, they can be valued like a perpetuity:
PV = \frac{D}{r}Where:
- PV = Present Value
- D = Annual Dividend
- r = Required Rate of Return
Example: If a preferred stock pays \$4 annually and the investor’s required return is 8\%, the fair value is:
PV = \frac{4}{0.08} = \$50Why Companies Issue Preferred Shares
Corporations issue preferred shares for several reasons:
- Flexible Financing – Unlike debt, missed dividends on preferred shares don’t trigger bankruptcy.
- Tax Efficiency – Dividends are paid from after-tax profits, but interest on debt is tax-deductible. However, preferred shares can still be cheaper than equity dilution.
- Attracting Conservative Investors – Some investors prefer stable dividends over growth potential.
Risks of Investing in Preferred Shares
While preferred shares offer stability, they aren’t risk-free:
- Interest Rate Sensitivity – Preferred shares behave like bonds; when interest rates rise, their prices fall.
- No Growth Potential – Unlike common stock, preferred shares don’t benefit much from company growth.
- Dividend Suspension Risk – Companies can suspend dividends (though they must pay them later if cumulative).
Real-World Example: Bank of America Preferred Shares
Bank of America (BAC) has issued several preferred stock series. One such series, BAC.PRL, pays a fixed 6.25\% dividend. If the market price is \$25, the yield is:
Dividend\ Yield = \left( \frac{1.5625}{25} \right) \times 100 = 6.25\%If interest rates rise and investors demand a 7\% yield, the price would adjust to:
PV = \frac{1.5625}{0.07} \approx \$22.32This shows how interest rate changes impact preferred share valuations.
Tax Implications of Preferred Shares
In the U.S., preferred dividends are taxed differently than bond interest:
- Qualified Dividends – Taxed at capital gains rates (0%, 15%, or 20%).
- Non-Qualified Dividends – Taxed as ordinary income.
Most preferred dividends are non-qualified, meaning they don’t get the lower tax rate.
Should You Invest in Preferred Shares?
Preferred shares suit investors who:
- Want steady income with lower volatility than common stock.
- Don’t need voting rights.
- Understand interest rate risks.
However, growth investors may prefer common stock for higher upside potential.
Final Thoughts
Preferred ordinary shares occupy a unique space between bonds and common stock. They offer predictable income but lack the growth and voting rights of ordinary shares. By understanding their mechanics—from dividend calculations to tax treatment—you can make informed investment choices.
