Common vs Preferred Shares

What are Common vs. Preferred Shares?

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.

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

• Equity or Common Shares
• Preference Shares

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

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.

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.

What Are Common Stocks?

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. 

Equity holders have the right to elect board members. They also have special voting rights that enable them to participate in company elections to choose the board of directors and other executive 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 equity shareholders, shareholders are entitled to voting rights and, during positive performance, receive a dividend from the company. 

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.

Equity Shares Based On Share Capital

1. Authorized Share Capital: Every company's 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 completing a certain legal procedure.
2. Issued Share Capital: Issued share capital is indicated by the specified portion of the company’s capital that 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 20,000 equity shares, the issued share capital equals $100,000.
3. Subscribed Share Capital: Subscribed share capital is the portion of the issued capital of the organization that the investors have subscribed to.
4. 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 refers to the same amount.

Equity Shares Based On Definition

1. Bonus Shares: Bonus shares are shares issued to the stakeholders without any additional charge (free of cost) or as a bonus.
2. 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.
3. 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.

Equity Shares Based On Return

1. Dividend Shares: Specific shares that often provide the shareholders returns in the form of frequent dividend payments are classified as dividend shares.
2. 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.
3. Value Shares: Shares traded at market prices lower than their intrinsic value 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 the Market Price of Common Shares

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

1. Demand and Supply: The most important factor affecting the price of a particular share on the stock exchange is the demand and supply of the share. If investors buy more shares, 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 common share prices

There are different ways to calculate the prices of shares in different financial markets. Some common methods include using the 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.

The formula is:

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?

Preference shares, also known as preferred shares, have a hybrid structure of common shares and fixed-income securities, 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 the 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 they pay a fixed rate of dividend over a given period, and the feature of equities as it possess the ability to appreciate in price.

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.

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 the remaining balance of dividends cannot be accumulated in future years.

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.

Convertible And Non-Convertible Shares

Convertible shares allow this preference shareholder to convert into equity shares with a predetermined conversion rate after meeting certain requisites of the company’s Article of Association (AOA).

In contrast, non-convertible preference shares cannot be converted into equity shares at any time. These shares provide the benefits of fixed dividends and are considered to be less risky than convertible preference shares. 

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.

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

Timely Dividend Payments 

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

This is because the economic device's character requires the agency to pay the concerned shareholders earlier than it 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.

Lower Default Risk

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

This way, in the unfortunate occasion of the firm's dissolution or completion, 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.

Priority In Events Of Claims

In the event of liquidation and bankruptcy, preference shares have a prior claim on the assets compared to equity shareholders. This prior claim in the assets ensures a guaranteed return on the investment to the preferred shareholders.

This prior investment will also include an unpaid or accumulated dividend to be paid to the preferred shareholders.

Less Risky

Preference shares are considered less risky than equity shares since the amount of money is guaranteed to be paid by the company in the event of bankruptcy and liquidation. 

This guarantee makes preference shares an attractive investment to the investors since they get priority in fixed dividend payments and the claim on the organization's assets.

No Voting Rights

One of the primary differences between preferred shares and equity shares is the availability of voting rights. If investors in preferred shares prefer it, they can enjoy the benefits of fixed payments without being involved in the company's decision-making.

Otherwise, any investor who wishes to engage in decision-making can opt to invest in equity shares.

Convertible Features

The convertible preference shares have the feature to convert them into common shares. This flexibility provides the investors with the option to convert at their discretion.

This conversion is executed at a predetermined conversion rate.

Flexibility In Capital Structure

Since preference shares do not amount to an ownership claim in the organization, the company can issue preference shares without diluting the ownership interest in the organization. 

The company can issue preference shares at their need of financing and capital structure needs, and maintain the control of the organization.

Common vs. Preferred Shares

It is important to understand that the main point of difference between common and preference shares is the point of ownership in the corporation, although this is not the only point of difference.

Common and preference shares can diffseveralber of categories, including voting rights, decision-making authority, the settlement of both categories in the event of liquidandtion & bankruptcy, dividend payandents & their policies, and many more.

Let us take a brief look at their differences.

In conclusion, its imperative we understand that none of the shareholders has the ultimate merits of owning one. Both classification of shares has their own advantages and disadvantages. Both of these shares have their point of difference.

The investors should decide where they would like to invest, suiting their goals and ambitions. Let us say, If the investors aim to acquire an ownership interest in the organization, they should choose Equity or Common Stock.

On the other hand, if the investors aim to get benefits only, like periodic dividends and prior claims on assets, then they go for preference shares.

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Forfeited Shares

• Non-Banking Financial Company (NBFC)

• Outstanding Shares

• Private vs Public Company

• Senior and Subordinated Debt