Difference Between Equity Shares and Preference Shares

Let's consider a simple example. Say, X and Y visit a market. X buys a standard product.  He gets a higher bonus based on company performance. Y chooses a premium package. He pays extra for guaranteed bonuses and priority to ensure a smoother, more predictable experience. Both get the product, but Y enjoys assured benefits.

This mirrors the basic difference between equity shares and preference shares. But the question that arises here is which one you should choose. Well, to get an answer to this, you first must understand what these two are and their difference. So let’s get started!

What are Equity Shares?

Equity shares are also known as ordinary or common shares. These represent a fundamental form of ownership in a company. When a company needs long-term financing, these shares are issued to various types of investors through various allotment methods

By allotting these shares, the company gives investors a stake in its ownership and growth. Hence, equity share represents a unit of that ownership. The funds raised from selling these shares help the company meet its financial needs.

Here are the key features of equity shares:

• Ownership Stake: Equity shares signify ownership in a company, making shareholders partial owners with a stake proportionate to the number of shares held by them.

• Voting Rights: Shareholders have the right to vote on certain company decisions. They have the power to participate in crucial events which can shape the future of the company.

• Dividend Income: Equity shareholders get dividends. This is a part of the profit they offer and is decided by the board of directors. This is a bonus for their investment in the company.

• Capital Gains: If a company is listed on any exchange, it is prone to price fluctuations. So, when the shareholders can benefit from selling the shares at a higher price than they bought and earn profits.

• Limited Liability: Shareholders' financial liability is limited to the amount invested in the shares.

• Bonus Shares: Companies may issue bonus shares to existing shareholders, increasing their shareholding without additional investment.

• Liquidity: As Equity shares of many companies are traded on stock exchanges, investors can buy and sell shares of such companies easily.

• Pre-emptive Rights: Existing shareholders may have the first right to purchase newly issued shares, helping them maintain their ownership percentage in the company.

What Are Preference Shares?

Preference shares are also known as preferred stock. These are unique types of equity that give shareholders priority over common shareholders in terms of dividend payments. They are a hybrid type of financing. They have the characteristics of both equity and debt instruments.

The key features of the preference shares are as follows:

• Dividend Priority: Preference shareholders receive dividends at a fixed rate. They get this before any dividends are distributed to common shareholders.

• Cumulative Dividends: With cumulative preference shares, if a company cannot pay dividends in a particular year, the unpaid dividends accumulate. These accumulated dividends are paid before any other shareholder receives the benefit.

• Liquidation Priority: In the event of a company's liquidation, preference shareholders have a higher claim on the company's assets than common shareholders. This offers some level of downside protection.

• Limited or No Voting Rights: These shareholders cannot vote in the company’s decisions. But there are certain conditions when it is allowed. It is as per company policy mainly.

• Fixed Income Stream: Preference shares offer a predictable and fixed dividend return. So, investors who want a regular income should go for this option.

• Convertibility: If the company permits, these shares can be changed to ordinary shares. This way the investors can gain capital benefit when the company is working well.

• Redeemability: Certain preference shares are redeemable, meaning the preference shareholders can sell them back to the company at a predetermined price and date.

Key Differences Between Equity Shares and Preference Shares 

Till now, you have got a brief idea of these two shares. Now, it's time to find the difference between equity and preference shares. This information is necessary to make investing decisions.

Now we know the difference between preference shares and equity shares, let’s understand the advantages and disadvantages of both for investors

Advantages of Equity Shares

1. Potential for High Returns

Equity shares offer a chance to earn higher returns. When compared to the other investment options, these offer you better opportunities for capital appreciation. However, for this, it is important to invest in top-performing assets. This requires proper analysis and market understanding. 

2. Dividend Income

As a shareholder, you may receive a portion of the company's profits in the form of dividends which can act as a passive source of income. This is when the company that you invest in is one with a history of regular payouts. So, you need to check your history and returns as well before investing.

3. Ownership and Voting Rights

Owning equity shares gives you a stake in the company. This means you have the authority to vote. While there can be a limit to where you can vote, you get this opportunity. This allows you to influence the company's direction and governance.

4. Hedge Against Inflation

Equity shares can be a valuable investment tool for hedging against inflation. While inflation decreases the overall purchasing power of money, investments in equity shares have the potential to grow at a faster rate than inflation. This can help protect the value of your money.

5. Portfolio Diversification

Equity investments allow you to diversify your portfolio across different sectors and industries, reducing overall risk. Diversification can help offset the impact of poor performance in any single area.

6. Liquidity

Equity shares are generally easy to buy and sell on stock exchanges, providing flexibility and quick access to your funds when needed. So, this allows you to change your decision based on market conditions and gain good returns. 

7. Bonus Shares

Companies may issue bonus shares, which increase the number of shares you own without requiring any additional investment. This allows you to gain more returns over time and gain higher voting benefits.

8. Limited Liability

Your liability as a shareholder is limited to the amount you invested in the shares. Your personal assets are not at risk if the company faces financial difficulties.

Disadvantages of Equity Shares

While equity shares are a great investment option, there are a few drawbacks, too. Knowing these will help you make the right investing decision. The primary disadvantages of equity shares are as follows:

1. High Market Volatility

Equity share prices are subject to significant fluctuations due to economic conditions, investor sentiment, and company-specific news, leading to potential short-term losses.

2. Lack of Guaranteed Returns or Income

Unlike fixed-income investments, equity shares do not guarantee any specific return or dividend income. Company performance directly impacts investment value.

3. Dividend Uncertainty

Dividend payouts are not guaranteed and are contingent upon company profitability and management decisions. Dividends may be reduced, suspended, or not issued at all.

4. Requires Financial Expertise

Successful equity investing often necessitates a solid understanding of financial markets, company analysis, and economic trends. Lack of expertise can lead to poor investment choices.

5. Risk of Capital Loss

The value of equity shares can decline, resulting in a capital loss if you sell your shares for less than the purchase price. Market downturns or poor company performance can exacerbate this risk.

6. Limited Shareholder Control

Shareholders typically have limited influence over a company's day-to-day operations and strategic decisions, potentially leading to dissatisfaction if management decisions negatively impact share value.

7. Liquidity Risk with Certain Stocks

While most equity shares are relatively liquid, shares of smaller or less actively traded companies can be difficult to sell quickly at a desired price, particularly during market downturns.

8. Potential for Dilution

The value of existing shares may become diluted if the company issues new shares, such as through rights issues or employee stock options, potentially impacting the share price.

Advantages of Preference Shares

Understanding the advantages of preference shares is crucial to determining whether they align with your investment goals. So, here are the advantages as follows:

1. Fixed Dividend Earnings

Preference shares provide consistent dividend payments, offering a reliable income stream for passive investors. 

2. Dividend Preference

When a company declares dividends, preference shareholders are prioritized and receive their payments before common shareholders, without exceptions. This makes the investment secure and safe.

3. Priority Claim on Assets

In the event of bankruptcy or liquidation, preference shareholders have a higher claim on the company's assets than common shareholders, increasing the likelihood of recovering a portion of their investment.

4. Potential for Additional Dividends

This is in the case of participating preference shares. So, if the company exceeds a specified profit target, shareholders may receive additional dividends. This will be in addition to their fixed rate. 

5. Flexibility

Companies can issue preference shares with various terms and conditions, enabling them to tailor investment to specific needs through features like cumulative or non-cumulative dividends, convertible or non-convertible options, and redemption clauses.

6. Flexibility of Conversion

Convertible preference shares provide investors with the option to convert their holdings into equity shares after a specified period. This allows them to benefit from potential capital appreciation while still enjoying fixed dividends until conversion.

Disadvantages of Preference Shares

There is no doubt that preference shares have many benefits. But there are certain disadvantages as well. Knowing them is important to understand whether you should go ahead with your investment or not. So, here are the disadvantages as follows:

1. No or Limited Voting Rights

Preference shareholders typically do not have voting rights, meaning they have little to no say in the company's management or decision-making processes.

2. Fixed Dividend Returns

Preference shareholders do not benefit from increased company profits beyond their fixed dividend rate, missing out on the potential for higher returns that common shareholders may experience.

3. Higher Cost for Issuing Company

From the company's perspective, issuing preference shares can be a more expensive way to raise capital compared to debt financing. This is due to the higher dividend rates often associated with preference shares.

4. Limited Capital Appreciation

Preference shares generally offer limited potential for capital appreciation, as their value is primarily driven by the fixed dividend rather than the company's overall growth prospects.

5. Fixed Dividend Obligation

The fixed dividend obligation can strain a company's finances during difficult economic times, as the company is still obligated to pay the fixed dividend even if it is struggling to make a profit.

6. Inflation and Interest Rate Risk

If inflation rises or interest rates increase, the fixed dividend rate of preference shares may become less attractive compared to other investment options with higher returns.

7. Lack of Significant Ownership

Preference shareholders do not have the same level of ownership or influence as equity shareholders, limiting their participation in the company's overall success and strategic direction.

Equity vs Preference Share: Which Should You Choose?

Here lies the big question. Now, you have the difference between equity share and preference share. You know the pros and cons. So, which one should you select? This is actually not an easy question to answer.  It is based on the risk and return capacity of the investor. So, to understand this better, here are a few conditions which you should consider.

Invest in Equity Shares If:

• Substantial capital appreciation is a primary goal.

• Regular market fluctuations and potential losses are acceptable.

• Voting rights and a say in company decisions are needed.

• Outpacing inflation is your objective.

Invest in Preference Shares If:

• A steady, predictable income through fixed dividends is a priority.

• A lower-risk investment compared to equity shares is preferred.

• Higher priority for dividend payments and asset claims during liquidation.

• Stability and capital preservation are the main aim.

Conclusion

Knowing the difference between equity and preference shares is the start of making the right investment decision. This is your baseline to understand what your aim is and where you should invest. 

Equity shares offer the potential for high growth; preference shares provide a more stable income flow. Likewise, equity shares' risk is greater than preference shares. Hence, it is important for you to carefully assess your risk tolerance, income needs, and long-term objectives before investing.

Once you’ve made your decision, it's time to take action. Open a demat account with Rupeezy to start investing and grow your wealth seamlessly

FAQs

Q1. Can preference shares be converted into equity shares?

Yes, some preference shares can be converted into equity shares. These are known as convertible preference shares. This is often after a set period and at a predefined ratio.

Q2. What are the similarities between equity shares and preference shares?

Yes, there are a few similarities between equity and preference shares. Both represent company ownership and help the company to raise capital. Investors can earn dividends through both options.

Q3. Which is riskier: equity shares or preference shares?

Equity shares are riskier due to price swings based on market sentiment and company performance. Preference shares are more stable with fixed dividends.

Q4. Can equity shares be converted into preference shares?

No, equity shares cannot be converted into preference shares. 

Q5. Are preference shares less volatile than equity shares?

Yes, preference shares tend to be less volatile as they offer a fixed dividend and have a higher claim on assets than equity in case of liquidation.

Q6. Can I sell preference shares in the stock market?

Yes, many preference shares are traded on exchanges, though their liquidity may be lower than that of common stocks, affecting how easily they can be sold.