Preferred stock is a special type of stock that pays dividends and does not come with voting rights. Preferred stock combines aspects of both common stock and bonds in one security, including regular income and ownership in the company.
- Preferred stock is a different type of equity that represents ownership of a company and the right to claim income from the company’s operations.
- Preferred stockholders have a higher claim on distributions (e.g. dividends) than common stockholders.
- Preferred stockholders usually have no or limited, voting rights in corporate governance.
- In the event of a liquidation, preferred stockholders’ claim on assets is greater than common stockholders but less than bondholders.
- Preferred stock has characteristics of both bonds and common stock which enhances its appeal to certain investors.
Understanding Preferred Stock
Preferred stock is a hybrid sort between a fixed and variable income security. It is an equity security with an intermediate claim between bondholders and stockholders on a firm’s assets and earnings.
In the event of liquidation, preferred stockholders have a claim on available assets before the common stockholders.
In addition, preferred stockholders get their stated dividends before common stockholders receive any dividends. Many issues of preferred stock are callable at a stated redemption price.
Preferred stocks are usually perpetual securities having no maturity date, although there are exceptions to the general rule.
Features of Preferred Stock:
However, the followings are the special features of preferred stock:
Some preferred stockholders have voting rights and some preferred stockholders do not have this right and voice in the management.
Preferred stockholders have a pre-emptive right to subscribe to additional issues of common stock but the non-voting preferred stock has no pre-emptive right.
Most preferred stocks have a par value. In this case, the shares’ cash dividend rights are usually stated at a percentage of par value.
Cash dividends are the most significant aspect of preferred stock in which the stockholders should get more gain from dividends than from capital appreciation.
Categories /Types of Preferred Stock
Preferred stocks can be categorized as follows:
Cumulative preferred stock: Holders of cumulative preferred stocks are entitled to a dividend whether the firms earn profit or not.
If the corporation misses a preferred dividend or any part of the ones, it is not lost but must be made up in a later year before any cash dividends can be paid the common stockholders.
Non-cumulative preferred stock: Holders of non-cumulative preferred stocks are entitled to a dividend if the firm earns the profit. If the corporation does not earn any profit, the dividend is lost to the preferred stockholders.
Participating preferred stocks: Participating in preferred stock is somewhat uncommon which is entitled to a stated rate dividend/ interest and a share of earnings available to be paid to the common stockholders,
The holders of participating preferred stocks are entitled to receive extra dividends when earnings permit.
Convertible preferred stocks: At the option of the holders, convertible preferred stocks may be converted into another security (generally a firm’s common stock) on stated terms.
Trust preferred stocks: These types of stocks are structured so that their dividend payments are treated as tax-deductible interest by the issuer.
Adjustable-rate preferred stocks: Adjustable-rate preferred stocks have cash dividends that fluctuate from quarter to quarter in accordance with the current market interest rates. These stocks are created to make cash dividend yield on preferred stock fluctuate with market conditions and thus be more competitive with bond investments.
Money market preferred stocks: Money market preferred stocks have finite life that expires very soon after they are used- some issues mature even after seven corporate investors. weeks. They typically offer a large denomination because they are targeted at large.
Why Buy Preferred Stock?
Depending on your investment goals, the preferred stock might be a good addition to your portfolio. Some of the main advantages of preferred stock include:
Higher dividends. In general, you can receive higher regular dividends with preferred shares. Payouts are also usually greater than what you’d receive with a bond because you’re assuming more risk.
Priority access to assets. If the company goes bankrupt, preferred shareholders are in line ahead of common shareholders, but still behind bondholders.
Potential premium from callable shares. Because preferred stock is callable, the company can buy it back. If the callable price is above the par value, you may receive more than you paid for the preferred stock.
Ability to convert preferred stock to common stock. When you buy convertible shares, you can trade in your preferred stock for common stock. If the value of the common stock drastically rises, you could convert your shares and benefit from its appreciation while investing in a less risky asset.
While preferred stock and common stock are both equity instruments, they share important distinctions.
First, preferred stock receives a fixed dividend as dividend obligations to preferred shareholders must be satisfied first. Common stockholders, on the other hand, may not always receive a dividend.
A company may fully pay all dividends (even prior years) to preferred stockholders before any dividends can be issued to common stockholders.
Secondly, the preferred stock typically do not share in the price appreciation (or depreciation) to the same degree as common stock. The inherent value of preferred stock is the ongoing cash proceeds investors received.
Common stock, on the other hand, is more difficult to value. However, because it is not tied to semi-fixed payments, investors hold common stock for the potential capital appreciation.
Lastly, the two types of equity have different terms or conditions. Preferred typically have no voting rights, whereas common stockholders do. Preferred stockholders may have the option to cover shares to common shares but not vice versa.
Preferred shares may be callable where the company can demand to repurchase them at par value. Preferred stock also receives better treatment during liquidations.