A Comprehensive Guide to Equity Shares and Preference Shares

by Maumita Mitra
13 June 20248 min read
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A Comprehensive Guide to Equity Shares and Preference SharesA Comprehensive Guide to Equity Shares and Preference Shares
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In the bustling arena of the stock market, knowledge is power. Investors seek to build their financial fortresses based on informed decisions.

One such critical decision lies in understanding various investment options in stock market and arm yourself with basics

e.g. what are equity shares and preference shares and the difference between equity vs preference shares.

Though they sound similar, equity shares and preference shares offer unique advantages and cater to different investment needs.

A Primer on Equity Shares

Equity shares, commonly known as common shares, represent the ownership capital of a company. An equity shareholder has a stake in the company’s assets and earnings proportionate to the number of shares held.

Here’s a step-by-step guide on how equity shares work:

  • Issuance: A company issues equity shares to raise funds. These shares can be purchased during an Initial Public Offering (IPO) or from the stock market once listed.
  • Ownership: Equity shareholders are partial owners of the company. Their ownership percentage equals the proportion of total outstanding shares they possess.
  • Voting Rights: Each equity share grants the holder voting rights in the company’s decisions, typically one vote per share.
  • Dividends: Equity shareholders are entitled to receive dividends, a portion of the company’s profits distributed to shareholders. However, the declaration of dividends is at the discretion of the company’s board of directors.

Understanding Preference Shares

Preference shares, as the name implies, provide certain preferences and privileges over equity shares. These shares are a hybrid form of financing, possessing characteristics of both equity and debt financing.

Let’s break down the nature of preference shares:

  • Preference in Dividends: Preference shareholders have the right to receive dividends before equity shareholders. These dividends are usually fixed and paid out regularly.
  • Preference in Liquidation: In the event of a company’s liquidation, preference shareholders are paid off before equity shareholders.
  • Conversion: Some preference shares are ‘convertible,’ meaning they can be converted into a fixed number of common shares under certain conditions.
  • Voting Rights: Preference shareholders generally do not have voting rights. However, if the company fails to pay dividends for a specified period, preference shareholders may gain voting rights.

Equity Shares Vs. Preference Shares: Key Differences

To understand the difference between equity shares vs preference shares, let’s delve into the distinct characteristics of each:

Dividend Rights

While both types of shares potentially offer dividends, their nature differs:

Equity Shares:

The dividends for equity shareholders are variable and are declared by the company’s board of directors. They are dependent on the company’s profit and are therefore uncertain.

For instance, if the ABC company declares a 20% dividend, an equity shareholder with 100 shares will receive 20 INR per share.

Preference Shares:

Preference shareholders enjoy a fixed rate of dividends, regardless of the company’s profit or loss.

If XYZ Ltd declares a 10% dividend for its preference shareholders, a shareholder with 100 shares will receive 10 INR per share, even if the company’s profits fall.

Repayment of Capital

In the event of liquidation, the order of capital repayment differs:

  • Equity Shares: Equity shareholders are at the end of the queue. They are repaid after all liabilities, including preference shareholders, have been settled.
  • Preference Shares: Preference shareholders have the right to be paid before equity shareholders in case of liquidation.

Voting Rights

The voting rights granted to shareholders also vary:

  • Equity Shares: Equity shareholders have the right to vote on major company decisions, with one vote typically per share held.
  • Preference Shares: Usually, preference shareholders do not have voting rights. However, in certain situations (like non-payment of dividends for a specific period), they may be granted voting rights.

Let’s understand the difference between equity shares and preference shares through a comparative table. 

Parameter
Equity Shares
Preference Shares
Example
Dividends
Variable, dependent on company profits
Fixed, declared at issuance
If ABC Company declares a 15% dividend, an equity shareholder with 100 shares gets 15 INR per share.

A preference shareholder of XYZ Ltd, with 100 shares and a declared dividend of 10%, gets 10 INR per share, irrespective of company’s profit.
Repayment of Capital
Paid after all other claims are settled
Paid before equity shareholders in case of liquidation
In case of liquidation, if ABC company has 1,000,000 INR left after paying off all liabilities and preference shareholders.

This amount is distributed among equity shareholders.
Voting Rights
Typically, one vote per share
Usually no voting rights, except in special circumstances
In a decision-making event, an equity shareholder of ABC company with 1000 shares has 1000 votes.

A preference shareholder of the same company generally has no votes.
Risk & Return
High risk, potentially high returns
Lower risk, stable returns
Equity shares of ABC company may see price appreciation of 20% in a year but also face the risk of a similar downside.

Preference shares of XYZ Ltd provide steady returns at a fixed dividend rate, say 8%.
Shareholder Rights
Residual claim on income and assets
Preferential rights to dividends and assets upon liquidation
If ABC Company makes a profit of 1,000,000 INR and declares a 10% dividend, equity shareholders receive their share after the preference shareholders of the same company have been paid their fixed dividends.

Analyzing Risk and Return Profile: Equity Shares vs Preference Shares

One primary difference between equity shares and preference shares lies in their risk and return profile.

Equity Shares:

These shares carry higher risk due to their residual claim on income and assets. However, they offer potential for higher returns as shareholders benefit from the company’s success in the form of capital appreciation and dividends.

Preference Shares:

These shares offer lower risk due to their preferential rights on dividends and asset liquidation. The returns, though stable and assured, are generally lower than potential returns on equity shares.

Here’s a table representing the risk and return profile:

Risk
Return
Equity Shares
High
High
Preference Shares
Low
Low to Moderate

Types of Preference Shares

Understanding the types of preference shares further underscores the difference between equity shares and preference shares. The main types include:

  • Cumulative Preference Shares: If a company cannot pay dividends in a particular year, they accumulate and are paid out in a year when the company generates enough profits.
  • Non-Cumulative Preference Shares: The dividends do not accumulate. If a company skips dividend in a year, the shareholder won’t receive it later.
  • Participating Preference Shares: Apart from fixed dividends, these shareholders have a right to participate in the surplus profit of the company.
  • Convertible Preference Shares: These shares can be converted into equity shares after a specific period.
  • Non-Convertible Preference Shares: These shares can’t be converted into equity shares.

Indian Context: Equity Shares vs Preference Shares

The equity shares vs preference shares debate assumes a unique dimension in the Indian context.

As per data from SEBI, equity shares are more popular among retail investors due to the dual advantage of voting rights and potential high returns.

However, the preference shares market is growing, thanks to their lower risk and regular dividends.

In conclusion, the difference between equity shares and preference shares is significant, and understanding it is vital to make well-informed investment decisions.

Whether you opt for the high-growth potential of equity shares or the steady income and preferential rights of preference shares depends on your financial goals and risk tolerance.

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FAQs

1. How many types of preference shares are there?

There are mainly five types of preference shares: Cumulative Preference Shares, Non-Cumulative Preference Shares, Participating Preference Shares, Convertible Preference Shares, and Non-Convertible Preference Shares.

Each type offers unique advantages and caters to different investor preferences.

2. How are preference shares issued?

Preference shares are issued through a Prospectus during an Initial Public Offering (IPO) or a Further Public Offering (FPO). Similar to equity shares, they are listed on the stock exchange and can be bought and sold.

3. Are preference shares transferable?

Yes, preference shares are transferable like any other shares, provided the company’s articles of association don’t restrict their transfer.

The process of transferring preference shares is similar to that of equity shares and can be done via a stock exchange or privately.

Key Takeaways

  1. The difference between equity shares and preference shares lies in dividend rights, repayment of capital, and voting rights.
  2. Equity shares carry higher risk but offer potentially higher returns. Preference shares offer lower risk and provide stable, albeit typically lower, returns.
  3. In the Indian context, while equity shares are popular among retail investors, the preference shares market is growing due to the stability they offer.
  4. A diversified portfolio with a mix of both equity and preference shares can help balance risk and returns.
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