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.

Features of Preferred Shares

Preferred shares have a special combination of features that differentiate them from debt or
common equity. Although the terms may vary, the following features are common:

 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.

Types of Preferred Stock

Preferred stock is a very flexible type of security. They can be:

 Convertible preferred stock: The shares can be converted to a predetermined

number of common shares.
 Cumulative preferred stock: If an issuer of shares misses a dividend payment, the
payment will be added to the next payment.
 Exchangeable preferred stock: The shares can be exchanged for some other type
of security.
 Perpetual preferred stock: There is no fixed date on which the shareholders will
receive back the invested capital.
Meaning:
Equity shares are the main source of finance of a firm. It is issued to the general
public. Equity shareholders do not enjoy any preferential rights with regard to
repayment of capital and dividend. They are entitled to residual income of the
company, but they enjoy the right to control the affairs of the business and all the
shareholders collectively are the owners of the company.

Features of Equity Shares

The main features of equity shares are:
1. They are permanent in nature.

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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.

4. Dividend payable to equity shareholders is an appropriation of profit.

5. Equity shareholders do not get fixed rate of dividend.

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6. Equity shareholders have the right to control the affairs of the company.

7. The liability of equity shareholders is limited to the extent of their investment.

Advantages of Equity Shares

Equity shares are amongst the most important sources of capital and
have certain advantages which are mentioned below:
i. Advantages from the Shareholders’ Point of View
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(a) Equity shares are very liquid and can be easily sold in the capital market.

(b) In case of high profit, they get dividend at higher rate.

(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.

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ii. Advantages from the Company’s Point of View:

(a) They are a permanent source of capital and as such; do not involve any
repayment liability.

(b) They do not have any obligation regarding payment of dividend.

(c) Larger equity capital base increases the creditworthiness of the company among
the creditors and investors.

Disadvantages of Equity Shares:

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Despite their many advantages, equity shares suffer from certain

limitations. These are:
i. Disadvantages from the Shareholders’ Point of View:
(a) Equity shareholders get dividend only if there remains any profit after paying
debenture interest, tax and preference dividend. Thus, getting dividend on equity
shares is uncertain every year.

(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.

(e) Issue of fresh shares reduces the earnings of existing shareholders.

ii. Disadvantage from the Company’s Point of View:

(a) Cost of equity is the highest among all the sources of finance.

(b) Payment of dividend on equity shares is not tax deductible expenditure.

(c) As compared to other sources of finance, issue of equity shares involves higher
floatation expenses of brokerage, underwriting commission, etc.

Different Types of Equity Issues:

Equity shares are the main source of long-term finance of a joint stock company. It is
issued by the company to the general public. Equity shares may be issued by a
company in different ways but in all cases the actual cash inflow may not arise (like
bonus issue).

The different types of equity issues have been discussed below:

1. New Issue:
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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.

i. Advantage of Bonus Issues:

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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.

ii. Disadvantages of Bonus Issues:

Issue of bonus shares decreases the existing rate of return and thereby reduces the
market price of shares of the company. The issue of bonus shares decreases the
earnings per share.

iii. Rights Issue:

According to Section 81 of The Company’s Act, 1956, rights issue is the subsequent
issue of shares by an existing company to its existing shareholders in proportion to
their holding. Right shares can be issued by a company only if the Articles of
Association of the company permits. Rights shares are generally offered to the
existing shareholders at a price below the current market price, i.e. at a concessional
rate, and they have the options either to exercise the right or to sell the right to
another person. Issue of rights shares is governed by the guidelines of SEBI and the
central government.

Rights shares provide some monetary benefits to the existing

shareholders as they get shares at a concessional rate—this is known as
value of right which can be computed as:
Value of right = Cum right market price of a share – Issue price of a new share /
Number of old shares + 1

Different Types of Stocks

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.)

Different Classes of Stock

Common and preferred are the two main forms of stock; however, it's also possible for companies to
customize different classes of stock in any way they want. The most common reason for this is the
company wanting the voting power to remain with a certain group; hence, different classes of shares are
given different voting rights. For example, one class of shares would be held by a select group who are
given ten votes per share while a second class would be issued to the majority of investors who are given
one vote per share.

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.

Benefits and Disadvantages of Equity Shares Investment

LIMITED LIABILITY
Liability of shareholder or investor is limited to the extent of the investment made. If the company goes
into losses, the share of loss over and above the capital investment would not be borne by the investor.

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.

CLAIM OVER ASSETS AND INCOME

An investor of equity share is the owner of the company and so is the owner of the assets of that
company. He enjoys a share of the incomes of the company. He will receive some part of that income in
cash in the form of dividend and remaining capital is reinvested in the company.
RIGHTS SHARES
Whenever companies require further capital for expansion etc, they tend to issue ‘rights shares’. By
issuing such shares, ownership and control of existing shareholders are preserved and the investor
receives investment priority over other general investors. Right Shares are issued at a price lower than
current market price of the equity share. So, existing investor can take that advantage or otherwise can
renounce right in some one’s favor to get value of right.
BONUS SHARES
At times, companies decide to issue bonus shares to its shareholders. It is also a type of dividend. Bonus
shares are free shares given to existing shareholders and many times they are given in lieu of dividends.
LIQUIDITY
The shares of the company which is listed on stock exchanges have the benefit of any time liquidity. The
shares can very easily transfer ownership.
STOCK SPLIT
Stock split means splitting a share into parts. How should an investor be benefited by this? By splitting of
share, the per-share price reduces in the market which eventually increases the readability of share. At
the end, stock split results in higher volumes with a number of investors leading to high liquidity of the
share.

Valuation Of Ordinary Shares

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:

P0 = Current value of common share

D1 = Dividend expected at the end of Year 1

r = Required rate of return on share

Dividend Valuation Models

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

2. Constant growth (Gordon Model)

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:

g = Constant growth rate

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.

Other approaches for valuation of shares:

Apart from dividend valuation approaches discussed above, there are few other approaches to valuation of shares. They are:

1. Book value approach

Value of a share = Net worth ⁄ Number of outstanding equity shares.

2. Liquidation value approach

Liquidation Value Per share =

(Value realized from liquidating all assets � Amount payable to creditors and preference holders) divided by number of outstanding shares

3. Price Earnings Ratio approach

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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