Level 1 CFA® Exam:
Common Shares vs Preference Shares
In this lesson, we're going to discuss different types of equity securities. We will be talking about:
- common shares, and
- preference shares.
If a company wants to undertake a project, it has to be able to finance it. There are generally 2 ways of financing projects, namely through debt and by issuing equity securities.
In the case of issuing securities, their holders become co-owners of the company and have a claim on its assets. When you invest in a company’s securities, you can achieve profit on the investment through stock price appreciation or dividend income. Let’s have a look at what else you gain by becoming a common or preferred shareholder.
Common shares, also called ordinary shares or common stock, are a kind of confirmation that the holder has ownership interest in the issuing company. Such shares grant many privileges to their holders. In the case of liquidation, the holders have a claim on the company’s assets. Upon the purchase, they can start benefiting from the operating performance of the company, and, thanks to the voting rights they gain, they may influence the way the company is governed.
The holders also have a right to elect the board, decide whether the company should merge with another entity or maybe take one over.
Statutory Voting vs Cumulative Voting
Many decisions regarding a company are made during the company’s general annual meeting or extraordinary general meetings. In such meetings, every shareholder may vote himself or vote by proxy when he cannot attend the meeting himself.
We distinguish among two major types of voting while electing members of a board of directors:
- statutory voting, and
- cumulative voting.
The total voting rights are set as the number of shares owned multiplied by the number of board directors that are being elected.
In the case of statutory voting, each share represents one vote. So, it is not allowed to give more than one vote per share on one nominee. In the case of cumulative voting, it is allowed to cast more than one vote per share on a given nominee. Even the total voting rights can be cast on one candidate.
Cumulative voting supports minority shareholders more than statutory voting.
Let's assume that an investor owns 1,000 shares and each share gives him one voting right. There are three board directors to be elected.
Calculate total voting rights and the maximum number of votes that the investor can cast on one nominee in case of statutory voting and cumulative voting.
Callable Common Shares vs Putable Common Shares
Callable common shares may be redeemed by the issuer from their holder at a prespecified price. Issuers usually exercise their right to redeem the shares when the market price is higher than the price at which the shares could be redeemed.
Putable common shares are similar type of shares. In this case, however, the holder has the right. She may sell shares back or, in other words, ‘put' them back to the issuer. Of course, she will sell back shares at a previously specified sale price. This operation will be profitable if the put price is higher than the market price. After exercising its right to sell back shares to the issuer, the investor may then buy shares of the same company at a lower price in the market and this way earn a profit.
Preference shares, also called preferred stock, are shares that give their holders more rights than common shareholders enjoy. First of all, a dividend they pay is usually higher than the dividend per share for common shares or they pay an extra dividend. Another privilege is the right of preference shareholders to a higher share in the company’s net assets upon liquidation.
- We distinguish between common and preference shares.
- Privileges of common shareholders: (1) shareholders benefit from the operating performance of the company, (2) shareholders may influence the way the company is governed, (3) shareholders have a right to elect the board or decide about merger or acquisition, and (4) in the case of liquidation, shareholders have a claim on the company’s assets.
- There are 2 major types of voting while electing members of a board of directors: statutory voting and cumulative voting.
- Cumulative voting supports minority shareholders more than statutory voting.
- Preferred shareholders have special rights as compared to common ones (e.g. higher dividend, higher share of net assets upon liquidation). However, they don’t enjoy certain rights that common shareholders have (e.g. they don’t have any voting rights).
- Convertible preference shareholders are entitled to convert their preferred stock to common shares if they wish to do so.