Difference Between Preference Share & Equity Share

Preference shares and common stock equity carry distinct advantages for investors.

Corporations issue stocks and bonds to finance ongoing operations. Shares of stock represent equity ownership, while bonds are actually loans from creditors. Due to their unique positioning within corporate finance, preference shares may be identified as hybrid securities that combine characteristics of both common stocks and bonds. Compare the risk versus return trade-off for preferred shares and common equity shares against each other, before making your own investment decisions.

Identification

Preferred shares benefit from asset claims that are superior to those on common equity shares. Preferred dividends accumulate, which means that preferred shareholders receive the totals of any missed dividend payments before the corporation can pay dividends on its common equity. During bankruptcy liquidations, preferred shareholders are paid before common equity shareholders.

Bondholders feature senior asset claims to both preferred and common shares. Corporations may pay dividends at their discretion. Missed bond interest payments, however, may subject the company to litigation and forced asset sales.

Features

Because of their senior asset claims, preference shares are more conservative investment options than common shares. Investors covet preferred shares for their regular dividend payments, which are generally larger than those on the common stock. Alternatively, common shares offer higher potential rewards, in exchange for higher risks. Common shares provide more opportunity for capital gains, where share prices may appreciate significantly over the long term.

Misconceptions

Common shareholders are awarded voting rights within the corporation. Although preference shares are equity investments, preferred shareholders are not authorized to vote. Common shareholders elect a board of directors, who then hire management executives to run the company.

Considerations

Participating and convertible preference shares are classes of preferred stock that enable conservative investors to benefit from business growth. Participating preference shares increase dividend payments when the underlying corporation surpasses predetermined standards in sales and profitability.

Convertible preferred stock may be converted into a particular number of common shares at any time. The conversion makes economic sense when common shares are trading above parity, in relation to prices on the convertible preferred shares. For example, you may be able to exchange two shares of your convertible preferred holdings for one share of common stock. Parity would exist when the convertible preferred shares trade for $50, while common shares are worth $100.

Convertible preferred shares might also be part of poison pills designed to thwart hostile takeovers. Outside investors purchase common shares to buy out a corporation, because common stock carries voting authority. Poison pills work by allowing convertible preferred shareholders to exchange their shares for large numbers of common shares when one shareholder acquires a certain percentage of the company. At that point, the number of common shares outstanding increases, which makes any hostile takeover more costly.

Warning

Because of smaller potential returns, preference shares are more exposed to inflationary risks than common stock equity. Inflation reduces the purchasing power of preferred dividends over time. Alternatively, common equity shares carry heightened business risks. Declining corporate profits may cause dramatic declines in common stock prices.

References

• Internal Revenue Service: Coporations
• Investopedia: Preferred Stock
• Investopedia: Common Stock

Resources

• Investopedia: Bond Basics
• Investopedia: Risk-Return Tradeoff