Common vs Preferred Shares

Both shares differ in their voting rights and dividends payments.

Shares that provide voting rights to the shareholders are known as common shares. On the other hand, preferred stocks are the ones that are more like hybrid securities (possess the features of both debt and equity); however, they do not provide voting rights to the shareholders.

Shares refer to equity ownership units in a corporation. Holders of such shares represent the organization's owners and are entitled to any future profit the firm earns. 

The total number of shares issued by the organization at a certain value helps to determine the total share capital of the firm, but this does not reflect the market value of the shares. 

However, the shareholders are also entitled to bear the losses incurred by the firm in a given financial year. In other words, a firm's shareholders own a portion of the organization in proportion to the number of shares held. 

The income earned by shareholders is received in the form of annual dividends, and the shareholder can realize capital gains by selling the shares at a price higher than the acquired share price.

Shares can broadly be classified into two different categories depending upon their voting rights, liquidation treatment, and profitability:

· Equity or Common Shares

· Preference Shares

Other classes of shares include deferred shares, redeemable shares, bonus shares, right shares, and employee stock option plan shares. Therefore, the firm uses these issued shares to grow and operate daily.

Equity Shares

Common stock is a share held by most of the organization's shareholders. Based on the overall concept of shares, common stock, also known as equity shares, refers to a unit of ownership in the firm. 

Moreover, the holders of common stock enjoy certain rights that their counterparts, i.e., preference shareholders, do not enjoy. 

Holders of equity have the right to elect the board of directors members. In addition, they have special voting rights that enable them to participate in company elections to choose the board of directors and other executives' positions.

However, in the event of liquidation, equity shareholders have the right to the company's assets after the accounts of the bondholders are settled, debt is paid in full, and preference holders are given their shares back. 

As an equity shareholders, the shareholders are entitled to voting rights and receive a dividend from the company during the positive performance. 

Moreover, there are different types of equity shares, and they can be classified into the following categories:

Types of Equity Shares

Equity shares of an organization can be classified into different categories as follows:

1) Equity shares based on Share Capital

Authorized Share Capital

Every company in its MOA must specify the maximum amount of capital that can be raised by issuing equity shares. The maximum limit can, however, be altered in the future by paying an additional fee and after completing a certain legal procedure.

Issued Share Capital 

Issued share capital is indicated by the specified portion of the company's capital, which has been offered to investors through the issuance of equity shares. 

For example, if the nominal value of 1 share is $5 and the company has issued 20000 equity shares, the issued share capital equals $100,000.

Subscribed Share Capital 

Subscribed share capital is the portion of the issued capital of the organization that the investors have subscribed to.

Paid-Up Capital

The amount investors pay for holding the company's stocks is known as paid-up capital. As investors pay the entire amount at once, subscribed and paid-up capital refer to the same amount.

2) Equity Shares based on Definition

Bonus Shares 

Bonus shares are those kinds of shares issued to the stakeholders without any additional charge (free of cost) or as a bonus.

Rights Shares 

Rights shares imply the category of shares issued by the firm to the existing shareholders at a given price for a specified period before the stocks get listed on the stock exchanges.

Voting and Non-Voting Shares 

Although most of the equity shares carry voting rights, the firm can issue some exceptions during the financial year, which carry no voting rights.

3) Equity Shares based on Return

Dividend Shares 

Specific shares that often provide the shareholders returns in the form of frequent dividend payments are classified as dividend shares.

Growth Shares

Shares of publicly listed companies with extraordinary growth rates and opportunities are known as growth shares. Such companies generally do not provide frequent dividends, so the investors profit from capital gains from share price increases.

Value Shares

Shares traded at market prices lower than the intrinsic value of the shares are known as value shares. Holders of such shares expect the prices to appreciate over time, thereby generating better Returns for the investors. 

Factors Affecting Market Price of Shares

Several key factors affect the performance of equity shares. These factors are explained below:

1. Demand and Supply 

The demand and supply of a particular share on the stock exchange is the most important factor affecting the price of the share. If a share is bought more by the investors, the prices will tend to rise as the demand for the share is greater than the supply.

2. Earnings and Profitability 

The company's earnings and profitability in a given financial period are crucial to fluctuations in its share price.

3. New shares issued 

Suppose a company issues new shares to raise funds from the market in the middle of a financial year, and investors display a positive attitude towards it and tend to buy shares. In that case, the supply will reduce the demand, thereby increasing the share price.

4. Buyback of shares 

If the company decides to buy back a given number of shares from the market, it will reduce the number of shares being traded on the stock exchange, thereby reducing the supply of the shares and leading to an increase in its price.

5. Other indirect factors 

Other factors such as interest rates, the economy's inflation rate, changes in economic policies, market sentiments, global fluctuations, and natural disasters affect the value of the shares being traded on the stock exchange positively or negatively.

Calculation of share prices

There are different ways to calculate the prices of shares in different financial markets. Some common methods of calculating share prices are with the help of price to earnings ratio

The shares' intrinsic value helps the investor determine whether the shares are overvalued against their market price. 

The intrinsic value of the share = (Price to earnings ratio) x Earnings per share (EPS) 

Another way of calculating the market price of the share is to adopt the dividend approach.

Formula

Price of the share = D/(k-g)

Where,

D = Dividends Declared

k = Expected Return on the share

g = Expected Growth rate of the share

For example, let us assume that Company XYZ ltd declared dividends worth $3 for the current financial year. Therefore, the expected Return on the share is 10%, whereas the expected growth rate is 3%.

Price of the share = 3/(0.10-0.03) = $42.86

Liquidity plays an important role in determining if a share can be sold in a financial market at a given time. Therefore, an actual transaction in the financial market where the buyer and seller meet to exchange shares tends to provide the best market indicator of the true value of the share. 

 What are Preferred Shares?

As the name suggests, preference stocks also have equity-like features in that these shares represent a unit of ownership in the organization. However, preference shareholders have a higher claim to dividend and asset distribution than equity stockholders.

The dividends paid out to the preference shareholders can be paid at a fixed rate or set against a benchmark interest rate like London Interbank Offered Rate (LIBOR) and is often quoted as a percentage.

Unlike the rights enjoyed by equity shareholders of the organization, preference shareholders do not have voting rights which means they cannot be a part of the annual general elections of the firm. 

Moreover, preference shares combine the features of debt and equity in the sense that it pays a fixed rate of dividend over a given period and the feature of equities as it possesses the ability to appreciate in prices.

As a result, it is an appealing form of investment to many risk-averse investors who aim to invest funds in safer instruments and demand a fixed payment rate at equal intervals. 

Furthermore, these shares are callable, implying that the issuer can redeem them at any time.

Types of Preference Shares

Preference shares can be classified into four different categories as follows:

1. Cumulative and Non-Cumulative Preference Shares 

For cumulative shares, if the firm does not declare an annual dividend in a given year, the balance is carried forward to the next financial year. In contrast, non-cumulative preference shares do not provide the opportunity to carry forward the balances to the next year.

As a result, such shares only offer an annual dividend, and a remaining balance of dividends cannot be accumulated in future years.

2. Participating and Non-Participating Shares 

Participating in preference shares allows the investors to receive surplus after profit on top of the fixed annual dividends they receive yearly. 

On the other hand, non-participating shares do not carry such benefits as receiving extra surplus and only offer a fixed annual dividend to the investors.

3. Convertible and Non-Convertible Shares 

Convertible shares benefit from being converted into equity after meeting certain requisites of the company's Article of Association (AOA). In contrast, non-convertible preference shares cannot be converted into equity instruments at any time.

4. Redeemable/Irredeemable Preference Share

A company with redeemable shares can repurchase or claim the preference shares at a given fixed price and period. These shares do not have any maturity date.

On the other hand, irredeemable preference shares carry no such conditions.  

Advantages of Preference Shares

Preference shares tend to offer the following advantages to the shareholders:

1. Tax Efficient

In many countries like the United States, income received from preference shares receives a preferential tax treatment. 

Certain preference shares have been listed down in a tax code, and the dividend received from such preference shares is taxed at a lower tax rate than regular income tax rates.

2. Timely Dividend Payments 

Firstly, it's crucial to know that desired shareholders are given precedence bills. 

This is because the character of the economic device is such that the agency has to pay the concerned shareholders earlier than they could make any bills to pay off the other shareholders of the organization.

These precedence bills assure coupon bills at a better price until the agency runs into coin waft problems and reaches the verge of bankruptcy.

3. Lower Default Risk

Preferred shareholders are considered senior within the firm's debt shape. 

This way, within the unlucky occasion of dissolution or finishing up of the firm, the desired shareholders can have a better declaration than fair shareholders. 

This way, the default danger of desired stocks is substantially decreased compared to the default danger of ordinary stocks.

4. Option to convert to common shares

Convertible preference shareholders offer the shareholder an option to convert to equity shares after holding the share for a given period. 

As a result, dividends paid by such shares tend to be lower than other classes of preference shares. 

Many investors prefer to invest their funds in such convertible shares as they get the opportunity to experience the features of both worlds.

For example, debt and equity as preference shares offer regular fixed dividend payments, similar to fixed interest payments in a debt arrangement. Also, they offer the benefit of earning a surplus after receiving dividend payments.

Common vs. Preferred Shares

Difference
Basis of DifferenceCommon SharesPreferred Shares
Voting RightsVoting rights are offered as per the proportion of shares held in the firmNo voting rights
Decision-Making PowerHigh power in the board meetings in terms of decision makingNo significant representation in board meetings and less control
SettlementSettlement for equity shareholders is done at the endPreference shareholders are paid after debt obligations and before equity shareholders.
Dividend PolicyNo fixed dividend and the dividend amount completely depends on the company's performance and policy.A fixed percentage of dividends is similar to interest payments on debt obligations.
Dividend Payment ObligationsNo obligation to pay dividendsIt is compulsory for firms to pay a fixed rate of dividend
Return on InvestmentsReturns are based on dividend payments and capital gains arising from increases in share prices.Returns are based on dividend payments only
ConversionsEquity shares cannot be convertedConvertible preference shares can be converted into equity shares after a given time.
RiskHigh riskMedium risk
Claim on AssetsThe last claim on a company's remaining asset upon liquidationPreference shareholders have a higher claim on assets than equity shareholders by lower than bondholders
Growth OpportunitiesHigh possibilitiesThe limited scope of growth, unless converted to equity shares 
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Researched and authored by Mehul Taparia | LinkedIn

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