Basic Finance Bootcamp Lesson 6: Preferred Stock

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We already talked about common stock in a previous post so this is a little out of order. However, better late than never. For completeness, here is a discussion about preferred stock. Enjoy.

Preferred Stock

When most corporations want to raise money, they do so by borrowing money or issuing new common equity (i.e., common stock).  However, some corporations also raise money by issuing preferred stock.  As is the case with a new common equity issue, new preferred stock is offered to the public through an initial public offering, after which investors buy and sell the preferred stock shares in the secondary market.

Like common stock, preferred stock is an equity position, although, unlike common stockholders, preferred stockholders typically do not have any voting privileges, except when triggered by an extraordinary event stipulated in the preferred stock agreement.  Preferred stockholders have priority over common stockholders, however, when it comes to payouts.  They receive their monies before common shareholders can receive anything in the event of bankruptcy.  This may be little or nothing, of course.  They must also be paid their dividends before common stock dividends can be paid.

Most preferred stock pays a fixed dividend, which is most often stated as a fixed percentage. Like common stock dividends, preferred dividends are not a legal obligation of the firm; in other words, a firm cannot be forced into bankruptcy for missing a preferred dividend payment.

Preferred stock may be either cumulative or non-cumulative. Cumulative preferred means that any preferred dividend payments that have been missed in prior periods must be paid up before common shareholders can receive anything.  For example, assume an issue of preferred stock pays a $4 dividend.  The following table shows the differing dividend payments to preferred shareholders, based on whether or not the preferred stock is cumulative:

In year 1, the board of directors does not declare a dividend, so none are paid.  In year two, dividends are declared.  If the preferred stock is non-cumulative, the shareholders get only the stated $4 a share.  If it is cumulative, the shareholders are paid the dividend that was missed in Year 1 in addition to the dividend for Year 2.

Most preferred stock is non-participating.  This means that no matter how well the firm does, the preferred stockholders will receive only the fixed dividend amount, while common shareholders may enjoy higher dividend payouts.  If a preferred issue is participating, the preferred shareholders will be paid a higher dividend if some specified threshold is met, such as a stipulated annual percentage increase in the earnings per share of the firm.  Along with everything else, this will be spelled out in the preferred stock agreement.

Most, but not all, preferred stock is callable, which means that the issuing firm has the right to buy it back from the investor at a price (the call price) that is stipulated in the preferred stock agreement.  This means you may be forced to sell back your shares at some point and find something else in which to invest your money.

Some preferred stock has a convertible feature, which allows the stockholder to exchange his or her shares of preferred stock for shares of common stock, in accordance with a conversion ratio specified in the preferred stock agreement.  So, if you notice that the firm is doing really well, you will be able convert your shares of preferred stock to shares of common stock.  As a common stockholder you will be able to enjoy the high returns that will accompany the firm’s superior performance. Remember that as a preferred stockholder, you’re typically limited to receiving the stated fixed dividend, regardless of how well the firm does.

Should you “prefer” preferred stock over common?  Not necessarily.  This depends on a number of factors, including your investment objectives, tax status, and current tax laws.  Preferred stock provides steadier, and usually higher, cash inflow in the form of dividend payments than common stock.  But, as noted above, you won’t enjoy the price appreciation in your preferred stock investment that you will when you are invested in the common stock of a company that does well since the preferred stock dividend is typically fixed, regardless of how well the firm does.

Some investors who have enough income from their jobs to support their current lifestyle often opt to invest in common stock that doesn’t even pay any dividends since they have to pay taxes on this dividend income, even if they reinvest it. (This will depend on the investor’s tax status and current tax laws, of course.)  Moreover, under current tax laws, capital gains aren’t taxed until they are realized, which occurs when the stock is sold.

The table below summarizes the major differences between common and preferred stock:

So, how do you buy preferred stock and where can you find all the specific details about an issue? To purchase the stock, you simply call your broker and place an order.  The broker’s representative will execute the trade for you just as he does an order to buy common stock.  Be sure to specify that you wish to purchase shares of the preferred stock of the company, not shares of the common stock.

Your broker can also provide you with all the information regarding a specific issue of preferred stock.  Another great source of information on preferred stock issues, as well as other investment vehicles, is www.quantumonline.com.  You have to register to be able to access the information, but registration is free.  You’ll find a table of all the preferred stock issues, along with a summary of almost all the information you’d want.  You can also click on the word “prospectus” in the next-to-last right-hand column to obtain even more information on the issue.

Okay–now you know everything you need to know about stock. If you have questions, ask now me below and don’t forget to sign up for my newsletter!