What Is Preferred Stock? How It Works With Example
Preferred stock is one of the two types of stock that enjoy priority over common stocks when it comes to dividends payments. Similar to common stocks, the preferred stock also represents partial ownership of a company.
As they are named preferred stock, they have some sort of preferential treatment over common stocks.
We will discuss these and more about preferred stocks in this article.
Let us understand what exactly preferred stocks are first.
What Is Preferred Stock-Definition
Stocks represent ownership of a company or an organization. The degree of ownership depends on the number of stocks of that company. Stocks are of two types: common stock and preferred stock.
Preferred stocks are those stocks that receive fixed dividends before the common stockholders. Here, there is a trade-off between preference and limited dividends.
They receive dividends before the common stocks but never get more than the fixed amount stipulated. In essence, you’re sacrificing profitability for stable and fixed returns with priority.
The fixed dividend amount remains static throughout and never changes. This affects the market value of the stock when the rate of inflation changes.
When the rate of inflation increases, the value of the preferred stock increases. Thus, they have an inverse relationship.
When the opposite happens, i.e. the rate of inflation decreases, then the value of the preferred stock increases. However, it never rises above the price at which it was issued.
Characteristics Of Preferred Stock
The first characteristic is that preferred stockholders always receive dividends before common stockholders.
Another way preferred stocks are different from common stock is that preferred stockholders are void from voting in the company elections, and board decisions.
Voting may not be required by all investors, but for some, it may be discouraging. The characteristics of preferred stocks fall somewhere in between bonds and common stocks.
It resembles common stocks in terms of equity and ownership. Moreover, the guaranteed fixed dividends make it similar to bonds.
Another way it is similar to bonds is in terms of credit ratings. Like bonds, preferred stocks are also given credit ratings. Thus it is considered as a hybrid of bonds and common stocks.
In the case of liquidation and bankruptcy, preferred stocks are given preference over common stocks in liquidating assets and dividend payment.
Why Do Companies Issue Preferred Stock?
Companies issue preferred stock for a variety of reasons. One of the main reasons is to generate capital via sales of these preferred stocks.
Issuing preferred stocks is a way of financing equity without giving away voting rights to the shareholders. Shareholders not being able to vote in company decisions ensure that they don’t take part in any takeover.
Companies pay fixed dividends to the owners of preferred stocks. They know these investors want a low-risk and stable form of investment. So, preferred shares are the perfect fit for that.
Investors know even in the case of bankruptcy, they are entitled payment before the common stockholders. Companies issue these stocks as they serve as a long-term investment tool. Preferred stockholders hold on to these stocks for more than 10 years, sometimes even between 30-50 years.
The dividend payment is fixed throughout its lifetime even if the company market cap and performance increases. In the case of common stocks, when the company grows, the value of common stock increases, and so does the dividend value.
Another big reason companies issue preferred stocks is that they rebuy these shares at any point in time. If the company wants to control the demand and supply of these shares, they can buy some of these back.
This might not always be appreciated by investors but for companies, it is a strong reason to issue these stocks.
Finally, issuing preferred lowered stock allows it to lower its debt-to-equity ratio and this makes the stock look more tantalizing to investors.
Not all companies issue preferred stocks despite the benefits it provides.
Example Of Preferred Stock Dividend Calculation
We have established the fact that the dividend payments for preferred stocks are fixed. We will see an example that will help us understand the dividend calculation for preferred stock:
Mark, an investor, decides to purchase 1000 preferred stocks of XYZ Corporation. Each stock has a par value of $10, and the dividend rate is at 5%.
In this case, how much dividend is he entitled to receive?
The formula for the preferred stock dividend is given as follows:
Preferred dividend = Number of preferred stocks x Par value of one stock x Dividend rate
Substituting these values into the equation, we get:
Dividend amount = 1000 x $10 x 0.05 = $500.
This means Mark will be paid $500 every year in dividends. This value remains fixed forever.
Types of Preferred Stocks
There are mainly 4 types of preferred stocks. Each has its own set of unique features. We have described them in detail in our article types of preferred stock.
Here we will give you a brief idea on them. The four types of preferred stocks are:
1. Cumulative Preferred Stocks:
If dividends are skipped for one year, then it is added up to the next year’s dividend.
If a company is unable to pay dividends for 2 years, then in the third year, it pays the shareholders a cumulative dividend of 3 years
2. Convertible Preferred Stocks:
These preferred stocks can be converted to a preset number of common stocks at any point in time. The conversion rate is decided before the stock issued publicly.
For example, one convertible preferred stock is equal to 5 common stocks when converted.
3. Participatory Preferred Stock:
These stocks pay extra dividends if the company meets certain financial goals. Apart from the fixed dividend, investors have a chance to earn extra depending on how well the company performs that quarter.
4. Callable Preferred Stock:
Companies that issues callable preferred stock has the right to rebuy these stocks from the investors.
A pre-defined buyback price and date are chosen when issuing these stocks. Companies can control the supply and demand of the shares by deciding how much to buyback.
Benefits And Features Of Preferred Stocks
In this section, we will discuss the various features of preferred stocks:
Preferred stocks possess the characteristics of both bonds and common stocks. Its fixed dividends make it similar to a bond and the nature of dividend payment makes it like common stock.
Thus you get features of both bonds and common stocks when you own preferred stocks.
Dividend Priority Over Common Stocks:
Preferred stockholders are paid before common stockholders. Preferred stocks have priority over the company’s income and therefore, enjoy this preferential treatment when it comes to dividends.
Fixed Dividend Amount:
When you own preferred stocks, you will be paid a fixed dividend amount at regular intervals. This amount stays constant irrespective of the company’s performance in the market.
Priority In The Event Of Bankruptcy:
If a company issues both preferred and common stock and it goes bankrupt, then it pays off the debt holders preferred shareholders first.
If an asset remains, it then pays the commons stockholders. Thus preferred stocks get priority in the case of both dividends and liquidation.
Preferred Stocks Can Be Cumulative:
If a company fails to pay dividends in a particular period, it is paid along with the next quarter’s dividend. Thus dividends for preferred stocks may be delayed, but never missed.
Preferred Stocks Are Convertible:
Some preferred stocks can be converted to common stocks. These stocks are known as convertible preferred stocks.
The conversion rate is pre-determined and you can convert them to common stocks at any point.
Preferred Stocks Are Re-callable:
At a pre-determined price and specific date, firms can redeem or rebuy the preferred shares. This allows firms more control and flexibility but is frowned upon by investors.
To counter this, firms pay a call premium, which is the difference between the buyback price and issue price.
Long/Unlimited Maturity Period:
Preferred stocks are usually perpetual, i.e. they last forever. Even if there is a maturity period, it lasts for long periods such as 30-40 years.
When the share matures, the firm pays you back the issue price of that preferred stock.
Drawbacks Of Preferred Stocks
Preferred stocks have certain limitations and shortcomings that we will discuss here:
1. Lack Of Voting Rights:
Apart from a few, most companies that issue preferred stock don’t provide voting rights to the shareholders.
Thus, they don’t have the control to dictate the direction in which the company will head.
2. Interest Is Not Tax-Deductible:
In the case of debt, the interest is a tax-deductible expense. But for preferred stocks, the interest is included in the tax calculation.
3. Limited Profitability:
Dividend payments are fixed throughout its tenure for preferred stocks. Common stock on the other hands has no limits on how high the dividend payment can be.
It scales directly with company growth and performance.
4. Affected By Interest Rate:
When the interest rate increases, the price of preferred stocks decreases. If the opposite happens, the value rises but not above the issue price.
5. Cannot Keep Up With Inflation:
As inflation increases every year, the returns from preferred dividends remain fixed.
It cannot keep up or counter inflation. In this case, common stocks perform better than preferred stocks.
When Can Dividends Be Variable For Preferred Stocks?
We have stated many times in this article that the dividends from preferred stocks are fixed. However, there is a specific type of preferred stock that offers variable dividends.
This preferred stock is known as adjustable-rate preferred stock (ARPS). As the name suggests, this is a preferred stock whose dividends vary depending on the Treasury bill rate and interest rate.
As these change, the dividend is adjusted accordingly. The dividend change is calculated based on a pre-set formula. The adjustment happens quarterly.
The change is not erratic and is often contained within a certain limit to ensure stability. The limits placed on the dividends are called collars. There are two collars, floor, and cap which determined the least and maximum dividend yield respectively.
Like other preferred stocks, adjustable-rate preferred stocks are also paid dividends before common stockholders.
The purpose of this guide was to familiarize you with the concept of preferred stocks. Along with common stock, it is a stock issued by companies to fund its expenses and give the shareholders a way to claim partial ownership in the company.
Preferred stocks are different from common stocks in many ways and we have discussed them here. Along with the features, we have listed the different benefits and risks that preferred stocks offer.
Finally, we discussed a special type of preferred stock that offers variable dividend payments. This stock is known as adjustable-rate preferred stocks.
If you are an investor looking to invest in preferred stocks, it is crucial to know its features before you invest in them. Not all companies issue preferred stocks. Check the offerings of the company and then invest wisely.