Deep Dive Into Preferred Stock
Looking into the characteristics of preferred stock and the difference between preferred stock, common stocks and bonds.
In this post, we’ll take a look at:
🧭 Key Takeaways
Preferred shares entitle their shareholders to receiving dividends in a fixed interval. If the preferred share is cumulative the dividends will accumulate in case the company pauses dividend payments. Contrary, a noncumulative dividend is not accumulating. A preferred share can also either be redeemable or perpetual. A redeemable preferred stock has a fixed lifespan while a perpetual preferred stock is outstanding until the company buys it back.
What Are Preferred Shares?
Preferred stock are company shares which entitle their shareholders to a fixed dividend in a fixed interval. The dividends paid by preferred stocks are prioritized over the dividends of common stocks. Preferred shareholders are also being prioritized over common shareholders in case the company gets liquidated. As the dividend is fixed the preferred shares can be classified as fixed income securities.
A dividend is a part of the companies earnings which is being distributed to the shareholders. Companies pay dividends in order to return value to their shareholders. It can be paid to common shareholders in both regular intervals or irregularly based on a decision of the company’s board. Preferred shareholders are entitled to a dividend in a fixed interval. This interval is either monthly, quarterly or yearly.
Contrary, common stock gives their owners voting rights in order to vote in shareholder meetings. These are usually held at least once per year. In addition they will be eligible for receiving dividends if the company decides to pay them out.
Why Do Companies Issue Preferred Stock?
A Company issues preferred stock in order to raise capital without increasing debt or shareholder dilution of common shares. They usually have multiple issues of preferred stock outstanding in order to take advantage of changing interest rates and other market conditions when issuing the preferred stock. These different issues are usually designated as Series A, Series B, etc.
What Is Special About Preferred Stock Dividend Payments?
Shareholder of common and preferred stock both receive dividends. However common stock dividends are at the sole discretion of the board of directors. As a result the frequency of dividend payments might change or a dividend might be omitted occasionally.
Contrary, preferred stockholders are entitled to a fixed dividend. The frequency and amount of the preferred dividend are set by the company. Like the common stock dividend the preferred stock dividend must be voted on by the board of directors.
While the company is not obligated to pay the preferred dividend it is a good practice to pay it in order to maintain a good reputation with investors. A company which has a reputation to always pay the dividend will have an easier time to raise further money through new issues of preferred stock. In addition it will likely attract a wider group and investors and possibly sustain higher common stock price.
How Is The Price Of Preferred Stock Determined?
The price of preferred stock is based primarily on the dividend yield. This is because preferred stocks pay out fixed dividends. As a result preferred stock prices tend to be more stable than common stock prices.
Contrary to the price of preferred stock, the price of common stock is determined based on the future outlook of the company. Therefore the price of common stock and preferred stock are not directly correlated.
What Is The Difference Between Preferred Stock And Bonds?
In many ways preferred stock act more like bonds than common shares. However despite their similarities with bonds preferred shares are treated like equity in the company.
Similar to the interest on bonds, preferred shares receive a fixed dividend. In addition, like bonds, some preferred shares must be redeemed (bought back by the company), may have a sinking fund or may be callable. Unlike the interest on a bond the company is however not contractually obligated to pay the dividend.
There is also a difference in how preferred stocks and bonds are taxed. Interest on bonds is a tax deductible expense. Contrary, dividends of preferred stocks are not an expense but instead are payments made from after tax profit. Therefore there are no tax savings for companies who issue dividends instead of paying interest on a bond.
What Is The Difference Between Perpetual And Redeemable Preferred Stocks?
Perpetual preferred stocks are stocks which may be outstanding forever unless the company buys them back on the secondary market and retires them. Redeemable preferred stocks on the other hand are preferred stocks which have a fixed life, similar to bonds. These have a redemption date at which they will be redeemed by the company. Some also may have a sinking fund or retirement fund.
Some preferred stocks are have an optional redemption feature which gives the company the right to set an early redemption date and buy back the preferred shares from the shareholders. In this case the preferred stock will no longer earn a dividend and therefore preferred shareholders have no reason to refuse the redemption of their share.
A company, on the other hand will prefer the optional redemption date as it will most likely result in better conditions than buying the preferred stock back on the open market.
What Is The Difference Between Redemption and Refunding?
A company can lower its preferred dividend obligations by issuing new preferred stock with a lower dividend. The proceeds from the newly issued preferred stock shares can then be used to redeem the previous preferred stock with a higher dividend obligation. This process is called refunding.
Refunding is not the same than redeeming preferred stock. Redemption happens when a company is redeeming preferred stock to retire it without replacing it.
What Is The Difference Between Noncumulative And Cumulative Preferred Stocks?
Preferred stock dividends always have priority over the common dividend of a company. Therefore if the preferred dividend is being omitted, common shareholder will also not receive a common stock dividend.
Once the preferred dividend on a noncumulative preferred stock has been resumed the company is free to declare common stock dividends again. Contrary when the preferred dividend on a cumulative preferred stock has been resumed the company first has to pay out all omitted preferred dividends before it can resume the common dividend.
What Are Convertible Preferred Stock?
Convertible preferred stock, also known as exchangeable preferred stock, are company shares which can be converted into common shares under certain circumstances. They can either be converted at any time or may have a specific time limitation. Some convertible preferred stock may specify a specific conversion rate which can change over time based on some specific factors like the profitability of the company. Preferred stocks which are not convertible are called straight preferred stock.
When a company has convertible preferred stock outstanding, the company is required to report both basic and diluted earnings per share. The basic earnings per share assume that convertible preferred stock has not being converted. The diluted earnings per share on the other hand assume that the convertible preferred stock have been converted to common shares.
What Are Adjustable Rate Preferred Stock?
A adjustable rate preferred stock has a variable dividend which is adjusted up or down with each dividend payment. The dividend payments are usually adjusted based on the yield of a benchmark interest such as LIBOR or a specified US Treasury Note. This is similar to the variable interest payments on variable rate notes. Adjustable rate preferred stock is also known as floating rate preferred stock.
What Are Auction Rate Preferred Stock?
Auction rate preferred stock require shareholders to periodically participate in dutch auctions. A dutch auction is a type of auction in which the seller sets a maximum price which is then lowered based on incoming bids. During the dutch auction the dividend rate of the auction rate preferred stock is being reset to the lowest rate where all preferred stock can be sold to buyers.
What Are Participating Preferred Stock?
The dividend of participating preferred stock can move up or down based on a predefined formula. The formula specifies when and by how much the dividend will change. Scenarios can include changes in earnings or changes in common stock dividends. Therefore the value of the preferred stock can move up or down based on the success of the company.
What Happens To Preferred Stock When A Company Is Being Liquidated?
When a company is being liquidated it first sells off all assets and pays of all liabilities using the proceeds. Any leftover money is then distributed to the stockholders.
In this case preferred shareholders have priority over common stockholder. Each preferred stock has a liquidation value which is being paid out first before common stockholders receive their share.
Different issues of preferred stock may have a different liquidation preference. When preferred stocks with a lower priority are also sometimes referred to as preference stock.
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