Last editedJun 20212 min read
What is a Preferred Stock?
Stock is a function of ownership or equity in a firm. This equity can be divided into two types of stock – common stock and preferred stock. In simple terms, shareholders who hold preferred stock have a better claim to dividends on that equity than those owning common stock. Beyond this general distinction, the details of how each preferred stock operates will depend upon the circumstances surrounding the stock being issued.
What is the difference between preferred stock and common stock?
The dividends paid to preferred shareholders are generally higher than those generated by common stock and can be paid monthly or quarterly. In many cases the dividends are set in line with a benchmark interest rate such as the London InterBank Offered Rate (LIBOR), and described as a percentage when the preferred stock is being issued.
Adjustable rate preferred stock pays a dividend that can vary, with additional dividends sometimes being payable based on common stock dividends or the profitability of the wider business. The board of directors of the company decide whether to pay the adjustable rate dividend.
The biggest difference between shareholders with preferred stock and those with common stock is that preferred shareholders have limited rights over the control of the company. Usually they will not be entitled to vote on decisions that the business takes. Investors who opt for preferred stock are usually looking for stable cash flows in the longer term.
Preferred stock and companies in distress
Some advantages of holding preferred stock come to light most clearly when a business is in crisis. A struggling business will sometimes have to suspend the payment of dividends. If this happens then holders of preferred stock may receive payments in arrears before holders of common stock get their payments once dividends resume. If shares operate in this manner they are known as cumulative shares, and some companies have multiple issues of preferred stock simultaneously. When this happens the multiple issues will often be ranked in order of preference running from “prior”, the top preference, through first preference and second preference etc.
Holders of preferred stock also have an enhanced claim to company assets in the event of liquidation, although they are still ranked beneath bondholders. If a company fails to pay a dividend to bondholders then the company is in default, but this is not the case with holders of preferred stock. Preferred stock is rated by credit agencies, but because preferred stockholders rank lower as creditors than bondholders the rating tends to be a little lower – this is balanced out by the fact that yields offered by preferred stock are higher.
The appreciation of preferred stock
Preferred stock is less likely to appreciate in price than common stock is, and the value of the stock generally stays within a few pounds of the issue price. Whether the value of preferred stock goes up or down varies, depending upon factors such as the credit rating of the business and the details of the original issue. These details might include whether the preferred stock is cumulative and what priority an issue has over other issues.
If preferred stock is callable, it means that the issuer can repurchase the stock after a specific date at face value. Sometimes, preferred stock can be converted to common stock under specific circumstances. These circumstances might include a vote by the board of directors, an option on the part of the investors or a date for conversion set in the original issue.
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