The 8 Advantages And Disadvantages Of Preferred Stock You Need To Know
Preferred stock, also known as preference shares, like common stocks, is issued by companies to raise capital.
Although both the aforementioned stocks save the same purpose for the company that issues them, they are different. Moreover, we have listed their differences in the article: Preferred Stock vs. Common Stock
Since there are different classes of stock, we must analyze each stock type to understand its features better.
In this article, we will focus on the advantages and disadvantages of preferred stock. But, if you are still unaware of the definition of preferred stock, then you can read what is preferred stock article.
Generally, through that article, you will know the basic definition of preferred stock with appropriate examples.
The 8 Advantages Of Preferred Stock
The preferred stock offers many benefits to its owners. Its benefits make it favorable over other forms of investment.
In this section, we will discuss the various attractive features of preferred stock. These are:
1. Guaranteed Dividend Payments:
Preferred stockholders are guaranteed fixed dividend payments regardless of how the company performs. Thus if you invest in preferred stocks, you can expect steady and stable returns.
With common stocks, there is no such guarantee. The company only pays you when it has paid other parties and has profits to spare.
2. Priority Over Common Stockholders:
Apart from guaranteed dividend payments, preferred stockholders enjoy the privilege of being paid dividends before common stockholders.
When a company fails to make a profit, they are still liable to the preferred shareholders to pay dividends.
3. Priority In The Event Of Liquidation And Bankruptcy:
As a preferred stockholder, you can be assured claim on the company’s assets over common stockholders.
With such security ensured to them, preferred stocks are a highly attractive option for investors when it comes to low-risk investments.
4. Variety In Preference Stocks Offering Extra Benefits:
We discussed different types of preference stocks in another article. There are 5 different types of preferred stocks each offering extra benefits to investors.
For example, convertible preferred stocks can be converted to common stocks when it is profitable to do so. For companies, they can repurchase stocks when they issue callable preference stocks.
Participatory preferred stocks offer extra dividends if the company meets certain target profits. Thus, the variety of preference stocks offers great diversity to investors.
5. Attributes Of Both Bonds And Common Stocks:
You get the best of both when you invest in preferred stocks. They get higher dividends than common stocks and get the preference as bondholders.
And similar to common stocks, owning preferred stock entitles you to partial ownership of the company whose stocks you own.
6. Low Risk Compared To Other Forms Of Investment:
As we discussed above, preferred stocks are considered safe to invest.
Even in adverse situations where the company fails to make profits, they are required to pay you dividends. In the worst-case scenario, the current year’s dividend will be paid in the next year.
This stock type is specifically known as cumulative preferred stock. In general, preferred stocks are less volatile than common stocks.
7. Easy To Invest:
Like common stocks, preferred stocks are easy to invest in. Online brokers have facilitated the process of buying stocks with just a click of a button.
Competent brokers don’t charge a high deposit amount to get started and the fees and commissions are quite low.
8. Other Benefits:
Apart from the aforementioned advantages, there are other benefits of investing in preferred stocks.
These include higher yield potentials, diversity in credit quality, increase the firm’s financial leverage, increased flexibility when compared to debt, and play an important role in corporate restructuring.
Disadvantages Of Preferred Stock
There are not many disadvantages of preferred stock but it has a few limitations that you need to be aware of before choosing to invest in them.
The drawbacks of preferred stock are as follows:
1. Limited Profitability:
Preferred stocks entitle you to fixed dividend payments that don’t increase with the increase in the stock’s value.
This is not the case with common stocks. Its value increases as the company’s profits and performance increases. The profit potential for the preferred stock is limitless.
If you invested in preferred stock of a company that performs well and has exponential growth, you’d still receive the same fixed dividends. In that case, investing in common stock would be a wise option.
Therefore, you need extra caution in finding which companies have stable growth and is not expected to raise much in value and at the same time it doesn’t decline either.
2. Inverse Relation With Interest Rates:
Although the dividend yield for preferred stocks is higher than common stocks, there is a downside to them. This has to do with the interest rate.
If there is a change in interest rate, the fixed value of the preferred stock also changes. If there is an increase in the interest rate, the fixed returns decline in proportion to it.
Thus the value of the preferred stock depends on the interest rate which is something no single entity controls. This is something to consider before investing in preferred stocks.
3. Cannot Combat Inflation:
One of the biggest advantages of common stocks is that it serves as a great tool to combat inflation. The return from common stocks outweighs that of the inflation rate and is a great way to deal with it.
On the other hand, preferred stocks have fixed dividend returns. It doesn’t increase with time, unlike common stocks. If inflation increases over time, there could be a chance that the increased costs could outweigh the returns from preferred stocks.
4. Dividend Payment Not Guaranteed Every Year:
If a company struggles financially, it has the right to not pay the shareholders any dividends. This also includes preferred stockholders.
The difference here is that while common stockholders may never be paid this dividend later, but the preferred stockholders will receive this money in the upcoming quarter.
For example, if a company goes through a rough patch and decides to not pay dividends for the upcoming 3 years. On the 4th year, preferred stockholders get paid dividends for the 4th year along with the previous 3 years of dividend.
The problem here is that there are investors who are not willing to wait for 3 years for a dividend payment. It might suit everyone’s investment style.
5. Preferred Stockholders Don’t Get Any Voting Rights:
Preferred shareholders don’t enjoy any voting rights when it comes to company matters and electing board members.
Thus their lack of control in these matters means they cannot do anything when a company they invested in goes in the wrong direction. This might defer some investors from investing in preferred shares.
Preferred shares are a great investment for those looking for steady returns. However, not all investors are willing to invest in them due to certain limitations.
In this article, we have taken a look at the various benefits and risks you will face when you invest in preferred stocks.
You get benefits such as cumulative dividends, priority over common stockholders, payment in the case of liquidation and bankruptcy, and much more.
On the other hand, there are certain shortcomings of preferred stocks. They have limited profitability, dependency on interest rates, lack of voting rights, and its inefficiency to combat inflation.
You can now analyze the pros and cons and make a decision if investing in preferred stocks would be the right choice for you.