Equity, often described as the ownership value in an asset or business, has many forms in the world of finance. One of the most intricate and versatile forms of equity is preferred ordinary shares. These financial instruments often perplex both seasoned investors and novices due to their unique combination of debt-like and equity-like characteristics. In this article, I will take you on a journey through the intricacies of preferred ordinary shares, breaking down their features, benefits, and risks, with real-world examples and calculations. By the end, you should have a solid understanding of these complex securities and how they fit into the broader landscape of corporate finance.
Table of Contents
What Are Preferred Ordinary Shares?
Preferred ordinary shares (often just referred to as preferred shares) are a class of equity that combine elements of both common stock and debt. Unlike common shares, which represent ownership in a company, preferred shares represent a hybrid security that offers some of the benefits of debt, such as fixed dividends, but also retains some characteristics of equity, such as voting rights in certain scenarios. These shares are generally issued by companies as a means of raising capital while avoiding the complexities of debt issuance.
The distinguishing feature of preferred shares is that they provide their holders with priority over common shareholders when it comes to dividends and in the event of liquidation. While they do not offer the same level of control over the company as common stockholders (in most cases), they come with a relatively stable dividend income and a higher claim on the company’s assets.
Key Characteristics of Preferred Ordinary Shares
Preferred shares come with several features that investors should understand. Some of the most important characteristics include:
- Dividend Priority: Preferred shareholders receive dividends before common shareholders. These dividends are typically fixed, unlike the variable dividends of common stock.
- Liquidation Preference: In the event of liquidation, preferred shareholders are paid before common shareholders. However, they are subordinate to creditors and bondholders.
- Convertible Option: Some preferred shares are convertible into common shares at the holder’s discretion, often under specific conditions. This feature allows investors to benefit from potential equity appreciation.
- Non-Voting Rights: Preferred shareholders typically do not have voting rights in corporate decisions, though this can vary depending on the terms of the issue.
- Cumulative vs. Non-Cumulative: Cumulative preferred shares mean that if a company misses a dividend payment, the missed payments accumulate and must be paid in full before common shareholders receive any dividends. Non-cumulative preferred shares do not have this feature.
Why Do Companies Issue Preferred Ordinary Shares?
Companies issue preferred shares for several reasons, most notably to raise capital without diluting control. Preferred shares are an attractive alternative for companies because they do not require them to give up voting control, as would be the case with issuing additional common stock. Moreover, these shares provide a relatively stable and predictable source of funding.
Benefits to the Company:
- Preservation of Control: Unlike common stock, which often comes with voting rights, preferred shares usually do not provide voting power to their holders, allowing the company’s founders or major shareholders to retain control.
- Debt-like Characteristics: Preferred shares offer fixed dividends, similar to interest payments on debt, but without the need for repayment, making them a less risky form of financing compared to traditional debt.
Benefits to Investors:
- Priority in Dividends and Liquidation: Preferred shareholders have a claim on dividends and liquidation proceeds before common shareholders, providing an added layer of security.
- Potential for Conversion: Convertible preferred shares allow investors to exchange their preferred stock for common stock if the company performs well, providing upside potential.
A Simple Example
Let’s look at an example to understand how preferred shares work in practice. Assume Company XYZ issues 1,000 preferred shares with a $100 par value and a 5% annual dividend.
- Dividend Payment: For each preferred share, the dividend is calculated as:
So, each preferred shareholder will receive $5 annually per share.
Total Dividend Payment: The total annual dividend payment to all preferred shareholders would be:
Liquidation Preference: If Company XYZ faces liquidation, the preferred shareholders would be entitled to receive the par value of their shares (i.e., $100 per share) before common shareholders receive anything.
Advantages and Disadvantages of Preferred Ordinary Shares
Like all financial instruments, preferred shares have their pros and cons. Let’s break them down:
Advantages:
- Stable Income: Preferred shares typically offer fixed dividends, providing a more predictable income stream than common stocks.
- Priority in Liquidation: In the event of bankruptcy, preferred shareholders are paid before common shareholders, though after debt holders.
- Potential for Conversion: Some preferred shares are convertible into common stock, which can be advantageous if the company’s stock price rises significantly.
Disadvantages:
- Limited Capital Appreciation: Preferred shares do not appreciate in value as much as common shares, limiting the potential for significant gains.
- No Control: In most cases, preferred shareholders have no voting rights, meaning they have no say in corporate governance.
- Interest Rate Sensitivity: Since preferred shares often have fixed dividends, their prices are sensitive to changes in interest rates. When interest rates rise, preferred shares may lose value.
Comparing Preferred Shares to Common Shares
It is important to understand how preferred shares differ from common shares. Here is a comparison table that highlights the key differences:
| Feature | Preferred Shares | Common Shares |
|---|---|---|
| Dividends | Fixed, paid before common shareholders | Variable, paid after preferred shares |
| Voting Rights | Typically none | Yes, one vote per share |
| Liquidation Preference | Paid before common shareholders | Paid after preferred shareholders |
| Capital Appreciation | Limited | Higher potential for growth |
| Risk | Lower risk, more stable returns | Higher risk, more volatile |
Tax Treatment of Preferred Shares
From a tax perspective, the treatment of dividends on preferred shares differs from that of common shares. Dividends on preferred shares are typically taxed at a lower rate than ordinary income, depending on the tax laws of the jurisdiction. In the United States, qualified dividends from preferred shares are taxed at a rate of 15% or 20% for most investors, depending on their income tax bracket. This tax advantage makes preferred shares an attractive investment for income-focused investors.
Using Preferred Shares in Portfolio Management
Preferred shares can be an essential part of a diversified investment portfolio. They offer a steady income stream and lower volatility than common stocks, making them appealing to risk-averse investors. For example, retirees or income-focused investors may allocate a portion of their portfolios to preferred shares to generate predictable cash flow.
One popular strategy for incorporating preferred shares into a portfolio is called “laddering.” This involves buying preferred shares with different maturity dates or call provisions, allowing the investor to manage interest rate risk and reinvest dividends at different rates over time.
Mathematical Models for Valuing Preferred Shares
Valuing preferred shares can be done using models similar to those used for bond pricing. The most common method is to treat the preferred shares as a perpetuity, assuming they will pay a fixed dividend indefinitely. The formula for valuing a preferred share is:
Where:
- Dividend per share is the annual dividend payment,
- Discount rate is the required rate of return, which reflects the investor’s risk tolerance and market conditions.
For example, if the annual dividend is $5 and the required rate of return is 6%, the price of the preferred share would be:
This is a simple model, and more complex models take into account factors such as the potential for the company to call the shares or convert them into common stock.
Conclusion
Preferred ordinary shares are a powerful tool in both corporate finance and investment strategy. Their hybrid nature, offering both debt-like and equity-like characteristics, makes them an attractive option for companies seeking to raise capital while maintaining control. For investors, they provide a stable income stream with the added benefit of priority in dividends and liquidation. However, like all investments, they come with trade-offs, including limited potential for capital appreciation and sensitivity to interest rate changes.
