A reader wrote in asking us where he can purchase preference shares from. Sure, they are much more beneficial than ordinary shares, but not that easily available. 

Here is a low-down on preference shares. 

There are two types of shares -- ordinary and preference.

Ordinary shares are exactly what the name signifies -- they are shares that are bought and sold in the stock market. 

Preference shares, on the other hand, are a little more special.

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What sets them apart

To understand preference shares, you will have to first understand what dividends are.

When you buy shares, you do not invest in the stock market. You invest in the equity shares of a company. That makes you a shareholder or part-owner in the company.

The good news is that, since you own part of the assets of the company, you are entitled to a share in the profits these assets generate.

If you sell the shares for more money than you picked them for, the profit you make is called capital appreciation.

You could also make money with dividends.

Usually, a company distributes a part of the profit it earns as dividend.

For example: A company may have earned a profit of Rs 1 crore in 2003-04. It keeps half that amount within itself. This will be utilised to buy new machinery or more raw material or to reduce its loan with the bank. It distributes the other half as dividend.

Assume the capital of this company is divided into 10,000 shares. That would mean half the profit -- ie Rs 50 lakh (Rs 5 million) -- would be divided by 10,000 shares; each share would earn Rs 500. The dividend in this case would be Rs 500 per share. If you own 100 shares of the company, you will get a dividend cheque of Rs 50,000 (100 shares x Rs 500).

Sometimes, the dividend is given as a percentage -- i e the company says it has declared a dividend of 50%. It is important to remember this dividend is a percentage of the share's face value (the original value of each share). This means, if the face value of your share is Rs 10, a 50% dividend will mean a dividend of Rs 5 per share.

However, chances are you would not have paid Rs 10 (the face value) for the share.

Let's say you paid Rs 100 (the then market value). Yet, you will only get Rs 5 as your dividend for every share you own. This, in percentage terms, means you got just 5% as your dividend and not the 50% the company announced.

Or, let's say you paid Rs 9 (the then market value). You will still get Rs 5 per share as dividend. In percentage terms, this means you got 55.55% as dividend yield and not the 50% the company announced.

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What's good about preference shares

1. You are assured of a dividend

If you own ordinary shares, you are not automatically entitled to a dividend every year.

The dividend will be paid only if the company makes a profit and declares a dividend.

This is not the case with preference shares. A preference shareholder is entitled to a dividend every year.

What happens if the company doesn't have the money to pay dividends on preference shares in a particular year?

The dividend is then added to the next year's dividend. If the company can't pay it the next year as well, the dividend keeps getting added until the company can pay.

These are known as cumulative preference shares.

Some preference shares are non-cumulative -- if the company can't pay the dividend for one particular year, the dividend for that year lapses.

2. They get priority over ordinary shares

Ordinary shareholders get a dividend only after the cumulative preference shareholders get theirs.

Preference shareholders are given a preference over the rest. That's why it is called a preference share.

3. Preference shares are safer

In case the company is wound up and its assets (land, buildings, offices, machinery, furniture, etc) are being sold, the money that comes from this sale is given to the shareholders. After all, shareholders invest in a business and own a portion of it.

Preference shareholders' get the money first. Their accounts are settled before that of the ordinary shareholders, who are the last to get paid.

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What's not good about preference shares

1. They are not easily available

Usually, preference shares are most commonly issued by companies to institutions. That means, it is out of the reach of the retail investor.

For example, banks and financial institutions may want to invest in a company but do not want to bother with the hassles of fluctuating share prices.

In that case, they would prefer to invest in a company's preference shares.

Companies, on the other hand, may need money but are unwilling to take a loan. So they will issue preference shares. The banks and financial institutions will buy the shares and the company gets the money it needs.

This will appear in the company's balance sheet as 'capital' and not as debt (which is what would have happened if they had taken a loan).

2. They are not traded on the stock exchange

The big disadvantage of preference shares, of course, is the fact that they aren't traded on the markets.

This means they are not 'liquid' assets; there's little scope for the price of these shares to move up or down.

On the other hand, ordinary or equity shares are traded in the markets and their prices go up and down depending on supply and demand for the stock.

But, that does not mean the investor is stuck with his shares. After a fixed period, a preference shareholder can sell his/ her preference shares back to the company.

You can't do that with ordinary shares. You will have to sell your shares to any other buyer in the stock market. You can only sell your shares back to the company if the company announces a buyback offer.

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As you see, preference shares are not really stocks -- they have many features of bonds, such as assured returns.

In fact, they are like fixed income instruments -- their value remains the price at which the company issued them, while their dividends are fixed, just like interest payments.

Sometimes though, preference shares have the option to be converted into ordinary shares.