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What Are Preferred Shares
What Are Preferred Shares
Preferred shares (also known as preferred stock or preference shares) are securities that
represent ownership in a corporation, and that have a priority claim over common shares on
the company’s assets and earnings. The shares are more senior than common stock but are
more junior relative to bonds in terms of claim on assets. Holders of preferred stock are
prioritized over holders of common stock in dividend payments.
Preference in assets upon liquidation: The shares provide its holders with priority
over common stock holders to claim the company’s assets upon liquidation.
Dividend payments: The shares provide dividend payments to shareholders. The
payments can be fixed or floating, based on the interest rate benchmark such
as LIBOR.
Preference in dividends: Preferred shareholders have a priority in dividend
payments over the holders of the common stock.
Non-voting: Generally, the shares do not assign voting rights to its holders.
However, some preferred shares allow its holders to vote on extraordinary events.
Convertibility to common stock: Preferred shares may be converted to a
predetermined number of common shares. Some preferred shares specify the date at
which the shares can be converted, while others require the approval from the board
of directors for the conversion.
Callability: The shares can be repurchased by the issuer at specified dates.
ADVERTISEMENTS:
2. Equity shareholders are the actual owners of the company and they bear the
highest risk.
3. Equity shares are transferable, i.e. ownership of equity shares can be transferred
with or without consideration to other person.
ADVERTISEMENTS:
6. Equity shareholders have the right to control the affairs of the company.
(c) Equity shareholders have the right to control the management of the company.
(d) The equity shareholders get benefit in two ways, yearly dividend and
appreciation in the value of their investment.
ADVERTISEMENTS:
(c) Larger equity capital base increases the creditworthiness of the company among
the creditors and investors.
(b) Equity shareholders are scattered and unorganized, and hence they are unable to
exercise any effective control over the affairs of the company.
(c) Equity shareholders bear the highest degree of risk of the company.
(d) Market price of equity shares fluctuate very widely which, in most occasions,
erode the value of investment.
(c) As compared to other sources of finance, issue of equity shares involves higher
floatation expenses of brokerage, underwriting commission, etc.
A company issues a prospectus inviting the general public to subscribe its shares.
Generally, in case of new issues, money is collected by the company in more than
one installment— known as allotment and calls. The prospectus contains details
regarding the date of payment and amount of money payable on such allotment and
calls. A company can offer to the public up to its authorized capital. Right issue
requires the filing of prospectus with the Registrar of Companies and with the
Securities and Exchange Board of India (SEBI) through eligible registered merchant
bankers.
2. Bonus Issue:
Bonus in the general sense means getting something extra in addition to normal. In
business, bonus shares are the shares issued free of cost, by a company to its existing
shareholders. As per SEBI guidelines, if a company has sufficient profits/reserves it
can issue bonus shares to its existing shareholders in proportion to the number of
equity shares held out of accumulated profits/ reserves in order to capitalize the
profit/reserves. Bonus shares can be issued only if the Articles of Association of the
company permits it to do so.
From the company’s point of view, as bonus issues do not involve any outflow of
cash, it will not affect the liquidity position of the company. Shareholders, on the
other hand, get bonus shares free of cost; their stake in the company increases.
There are two main types of stocks: common stock and preferred stock.
Common Stock
Common stock is, well, common. When people talk about stocks in general they are most likely referring
to this type. In fact, the majority of stock issued is in this form. We basically went over features of common
stock in the last section. Common shares represent ownership in a company and a claim (dividends) on a
portion of profits. Investors get one vote per share to elect the board members, who oversee the major
decisions made by management.
Over the long term, common stock, by means of capital growth, yields higher returns than almost every
other investment. This higher return comes at a cost since common stocks entail the most risk. If a
company goes bankrupt and liquidates, the common shareholders will not receive money until the
creditors, bondholders, and preferred shareholders are paid.
Preferred Stock
Preferred stock represents some degree of ownership in a company but usually doesn't come with the
same voting rights. (This may vary depending on the company.) With preferred shares investors are
usually guaranteed a fixed dividend forever. This is different than common stock, which has variable
dividends that are never guaranteed. Another advantage is that in the event of liquidation preferred
shareholders are paid off before the common shareholder (but still after debt holders). Preferred stock
may also be callable, meaning that the company has the option to purchase the shares from shareholders
at anytime for any reason (usually for a premium).
Some people consider preferred stock to be more like debt than equity. A good way to think of these
kinds of shares is to see them as being in between bonds and common shares. (If you don't understand
bonds make sure also to check out our bond tutorial.)
When there is more than one class of stock, the classes are traditionally designated as Class A and Class
B. Berkshire Hathaway (ticker: BRK), the company of Warren Buffett (one of the greatest investors of all
time), has two classes of stock. The different forms are represented by placing the letter behind the ticker
symbol in a form like this: "BRKa, BRKb" or "BRK.A, BRK.B".
CAPITAL GAIN
The other source of return on investment apart from dividend is the capital gains. Gains which arise due
to rise in market price of the share.
EXERCISE CONTROL
By investing in the company, the shareholder gets ownership in the company and thereby he can
exercise control. In official terms, he gets voting rights in the company.
Ordinary shares are also called as equity shares or common shares. Investors invest in equity
shares with an expectation of dividends and growth in dividends and to benefit also through capital gains
when they sell it. They typically purchase the common shares when the market value is lower than its true
value and sell it when the market value is more than its true value, thus realizing a capital gain on the
transaction. Some investors expect that the company would grow well in future and in anticipation of that
retain their shares for a longer time. The value of an ordinary share is equal to the present value of all the
expected future dividends over an infinite period. Symbolically, it can be expressed as:
Where:
Valuation of shares can be with respect to 1) Zero growth 2) constant growth and 3) Variable growth
1. Zero growth
As per this approach, it is assumed that the dividends are constant with non-growing feature. The value of the share would
simply be the expected dividend divided by the required rate of return.
P = D1 ⁄ r
As per this approach, the dividends are expected to grow at a constant rate. The value of the share as per this approach would
be:
P = D1 ⁄ (r-g)
Where:
3. Variable growth
As per this approach, the growth rate in dividend changes. The steps involved in valuing a share based on this approach would
be:
a. Computation of value of cash dividends at the end of each year during the initial growth period.
b. Computation of present value of the dividends expected during the initial growth period.
c. Finding the value of the share at the end of the initial growth year, which would be the present value of all dividends expected
from the end of initial growth year till perpetuity assuming a constant growth rate.
d. Adding of the present value components found in b) and c) and this would be the value of the share at the current date.
Apart from dividend valuation approaches discussed above, there are few other approaches to valuation of shares. They are:
This reflects the amount investors are willing to pay for each rupee of earnings. = (1-b) ⁄ r � (ROE x b)
Where:
1-b = dividend pay-out ratio
r = required rate of return
ROE x b = expected growth rate
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