Oran Hall | Ordinary and preference shares uncommon in many ways
Ordinary shares and preferrally have no legal obligation to pay, the decision being left to the discretion of the directors.
There are differences in the dividends of these two types of securities. Dividends on ordinary shares, also called common stock, are paid from the current or accumulated profits of a company but after dividends on preference shares are paid.
Dividends on preference shares may be a fixed amount or stated percentage of the face value of the security, but may also be at a variable rate whereby the rate may be, for example, a set amount of percentage points above the market-determined yield of a particular debt security, such as a treasury bill.
The fixed rate, or how the rate for variable preference stock is determined, is established and stated even before the shares are sold to investors. The information would be included in the prospectus for the share offer and on the share certificate, if there is one.
This is not the case with ordinary shares. The size of the dividend to be paid is recommended by the directors and approved by the shareholders, so it may vary significantly over time; and the directors may recommend a small dividend or no dividend even when a company is making good profits, if, for example, the directors see it necessary to preserve funds in the business to facilitate future expansion.
Preference shares have many different features, several of which may be found in one issue. For example, they may be redeemable, cumulative, convertible, participating, as well as carry a fixed rate or variable rate.
Unlike non-redeemable preference shares, redeemable shares have a limited life in that they may be bought back by the issuer. How long they are issued for also varies. In recent times, we have seen issues with a five-year or ten-year term in our market, but in 2014, student housing developer 138 Student Living Jamaica Limited issued preference shares to be redeemed in 30 years.
In the case of cumulative shares, dividends not paid when due will accumulate and paid at a future time, while convertible preference shares are convertible to ordinary shares at a set price and ratio. Participating shares are able to share in the profits of a company in addition to the regular dividend payment if the conditions stipulated are satisfied.
Whereas the price of ordinary shares may fluctuate significantly, the price of preference stock is more stable. The profit a company makes has a strong bearing on the price of ordinary shares, but the price of preference shares is influenced largely by changes in interest rates, generally rising when rates fall and falling when they rise.
Convertible preference shares differ, though. Their price is also influenced by the price of the ordinary shares into which they are convertible. The higher the price of those ordinary shares, the more valuable the preference shares.
The principal invested in preference shares is safer than that invested in ordinary shares, not only because of the lower level of price fluctuation when interest rates are stable, but by the fact that preference shares rank above ordinary shares in the event of the dissolution of the company.
In terms of the protection of the value of preference shares in the secondary market, variable rate shares are better as their prices generally fluctuate less than fixed rate shares.
Preference shares are suitable for investors who have a low level of risk tolerance, or have a desire for a steady, reliable flow of income. Ordinary shareholders, while also desiring income in the form of dividends, have a preference for income which increases over time as profits increase.
Beyond that, the owners of ordinary shares expect to get significant returns on their investment from capital appreciation, especially over the long term, but recognise that poor company performance and unfavourable market conditions may result in them making losses, so they have a higher tolerance for risk.
The voting rights of ordinary shareholders are far wider than those of ordinary shareholders in that they can vote on all resolutions as opposed to the preference shareholders whose voting rights are generally limited to matters relating to the variation of their rights, such as the creation of new preference shares ranking equally with existing preference shares or the early redemption of redeemable shares.
For balance, ordinary shares and preference shares have a place in any portfolio.
- Oran A. Hall, author of Understanding Investments and principal author of The Handbook of Personal Financial Planning, offers personal financial planning advice and counsel. firstname.lastname@example.org