Preferred Stock: Definition, Pros, Cons & Examples
What is Preferred Stock
A preferred stock is a type of stock that receives preferential treatment over common stock. It is often seen as a mix between a bond and a stock. This is because owners of a preferred stock have a set amount in dividends that they receive each year – similar to a bond. However, it also represents ownership of the company and is traded on the stock exchange – just like a stock.
A preferred stock owner will have a number of benefits over common stock. Not only do owners receive higher dividend payments, but they also receive preferential payment. For example, if a company has $100 million to pay shareholders, the preferred stock owners will receive their payments first. Anything left over will be distributed to the common shareholders.
- A preferred stock is a stock which has preferential treatment over a common stock, but acts in a similar way to a bond.
- Business can offer a number of different ‘classes’ of preferred stock that offer different rates.
- A preferred stock may be beneficial to investors who want to limit risk with a guaranteed yearly income.
In addition to preferred stock owners receiving higher dividends, they also benefit in the event of the companies collapse. Once the firm goes under and its assets are sold, preferred stock owners will receive their investment back before common stock owners.
Understanding Preferred Stock
A preferred stock is very much a mix between a stock and a bond. Whilst it is traded on the stock market, it doesn’t see the same increases and decreases in value like a common stock. Instead, its value is similar to a bond.
Both bonds and preferred stock offer a fixed amount. However, bond repayments are interest payments based on debt. By contrast, preferred stocks receive dividends. These are not guaranteed in the same way bond repayments are. If the firm is doing badly, it may not have to repay the dividends – although these can roll over into subsequent years when the company is doing better.
As preferred stock is valued much like a bond, its performance has a greater relation to interest rates than the firms performance. For example, high growth technology stocks are likely to re-invest profits into the firm than pay dividends. This re-investment into the company benefits common stockholders over preferred shareholders as it increases the firms valuation.
From the perspective of a preferred stock owner, they will be due their 6 percent dividend payment whether the firm grows 100 percent or not at all. So any noise around growth can be seen as irrelevant to a degree. Obviously if the firm tanks heavily, then this can have an impact.
- Higher preference on dividend payments
- Higher dividend yields
- Preference over assets in event of liquidation
- Higher dividend payout for higher risk
- Some may allow convertibility to common stock
- Have no voting rights
Advantages of Preferred Stock
1. Higher Dividends
One of the most attractive advantages of preferred stock is that it typically pays a higher dividend than common stock. This is because it works in a similar way to a bond whereby the owner is paid a fixed rate each year. However, unlike a bond, the investor takes on more risk. The company can delay payments to stockholders, but not bondholders. In the event of bankruptcy, bondholders are also paid ahead of preferred stock owners. So it is understandable that such stockholders receive a higher return for the higher risk.
At the same time, it doesn’t have the same capital benefits as a common stock. In other words, it doesn’t appreciate in value the same way. Whilst a common stock may increase by 20 percent, a preferred stock is unlikely to move much. This is because its valuation is influenced in a similar way as a bond rather than the firms performance. In turn, companies need to offer higher dividend rates to investors to account for this drawback.
2. Fixed Dividends
Preferred stock owners benefit from a fixed rate dividend which doesn’t fluctuate. When a firm does well, it may offer common stockholders a higher dividend. Yet when it does badly, it may remove the dividend entirely.
For those with preferred stocks, they can almost guarantee payment. As they have preferential treatment over common shareholders, they will receive their dividend payment first. So even if the business makes little profit, they will receive their dividends first.
When the firm is doing badly, preferred stockholders may not receive payment. However, for those with cumulative shares, these unpaid years will accumulate until the firm is back in profit. At that point, they will receive the unpaid dividends which they were due to receive.
3. Higher Claim on Company Assets
If the firm collapses, its assets go through liquidation. This is where its assets are sold off in order to raise capital to pay off its various stakeholders. The legal order by which they get paid varies slightly from country to country. However, preferred stock holders will always receive their investment ahead of common stock owners.
At the same time, it has a lower claim compared to alternative stakeholders such as bondholders and suppliers. Yet this higher risk is compensated for by higher dividends and favorable tax rates.
4. Convertible Shares
Some preferred shares offer a type of share known as ‘convertible shares’. These let investors trade in their preferred stock in return for a certain number of common shares. Depending on the value of the common stock, this can prove extremely lucrative.
This type of subcategory overcomes one of the biggest disadvantages of preferred stock – low equity growth. Owners are then able to benefit from the fixed dividend payments and then cash out when the companies share price increases.
5. Lower Cost of Raising Capital
From the businesses point of view, preferred stocks get round a tricky issue. When issuing more common stock, it dilutes the value of the existing stocks. For example, there are 1 million stocks on the market at $1 each. The firm introduces a new round of funding an increases the number of stocks to 1.1 million. In turn, the initial $1 value will drop to accommodate for the increase in supply.
This dilution process can come at a cost to the business. Instead, preferred stocks don’t have this same issue as they act in a similar way to a bond. The increase in issuance has little impact on similar stocks on the market.
6. Preferential Tax
Income from bonds come in the form of interest payments, which are liable for personal tax. However, income from preferred stock comes in the form of dividend payments. This can create tax benefits for investors, depending on their existing income level.
There are also common stocks which see the majority of their gains through increases in value. In turn, this is liable for capital gains tax. This can vary depending on whether the shares are held short or long-term. Short term stocks are usually taxed in the same fashion as income tax.
However, long-term capital gains often have more favorable rates. For example, in the USA, these range from 0 to 20 percent, which is comparable to its dividend rate. So although preferred stock often has better rates than short-term common stocks, it is on par with long-term holdings.
7. Issuance of Callable Preferred Stock
Callable preferred stocks are where the issuing firm has the right to repurchase the outstanding shares at any time. This is advantageous because it is able to repurchase these when better rates are available.
For example, the callable shares may have a dividend rate of 6 percent. At the time of issuance, this might have been a competitive rate. However, if interest rates drop to 2 percent, this makes alternative forms of credit significantly cheaper. It may be able to offer another round of preferred stock at a lower dividend rate, or purchase bonds with an interest rate closer to 2 percent.
It must be said that whilst this is an advantage for the firm, it is also a potential disadvantage for the investor. Yet at the same time, there is little risk as they will receive their initial investment back.
Disadvantages of Preferred Stock
1. Lack of Voting Rights
Preferred stock owners have no say in how the company is run. Whilst you could also say that for the average common stock owner, they at least have a voting right which has the potential to influence policy.
For most investment firms, they will want influence over decision making in the business. So a lack of voting rights is immediately a massive drawback. Yet for the casual investor, this might not be so much of an issue.
Nevertheless, the lack of voting rights is compensated by higher payments. Whilst this negates some of the disadvantages to the investor, it also creates a higher cost to the business.
2. Time to Maturity
Not all preferred stocks have a maturity date, but some do. This means that at a specific point in the future, the company must re-pruchase that stock at a predetermined amount. For owners of such stock, this brings about one of the disadvantages of a bond, but also with the downsides of a stock.
As such preferred stock acts and reacts like a bond, it is sensitive to interest rate changes. This can create a huge risk to investors who will need to consider the time-to-maturity and the impact any interest rate fluctuations may have.
3. Potential Lack of Dividend Payments
Some high growth companies, particularly in the tech industry, will often use profits and re-invest these. This means that the profits which would otherwise be paid out as dividends is re-invested into the company. Now this helps with the firms growth and will benefit common stockholders, but is to the detriment of preferred stock holders.
There is also the case of a company which is failing. If it’s not producing any profits, it’s not providing any dividends. In the long-term, this might not affect preferred stock holders as they may be able to re-coup these losses during the good years. However, some firms may never return to profit again.
4. Limited Upside
The issue with a preferred stock is that it’s a half-way house between a bond and a stock. It doesn’t receive the same treatment as a bond. For instance, bondholders have a higher claim to assets and generally get paid regardless of whether the firm makes a profit or loss. By contrast, an owner of preferred stock is not necessarily guaranteed a dividend if the company makes a loss or decides to re-invest.
At the same time, stocks can offer far greater potential in terms of asset value. Whilst some firms may offer a yearly dividend of 5 percent a year, other high growth firms may out-pace that growth.
5. Lack of Diversity
Most preferred stock options are offered by financial service providers, thereby offering very little market diversity. For those investors looking at preferred stocks, there are limited opportunities outside of this area. There are some small start up businesses, but these obviously come with a high risk.
At the same time, investments in preferred stock will be heavily influence by events within the financial services sector. These stocks are already affected by interest rates, so those issued within the financial services will face even greater forces. This could lead to some significant declines or increases in the assets price, but also, greater volatility.
6. Lack of Equity Growth
There isn’t anything quite like purchasing a stock and seeing it increase by 10 or 20 percent within a few months. The issue with preferred stock is that owners don’t benefit from any stock price gains. Perhaps with the exception of those which have convertibility.
The return on investment comes through via a dividend payment. Whilst this often offers an almost guaranteed stream of income, it doesn’t quite offer the same growth opportunities of common stocks. It’s a rather passive and risk free option in comparison to common stocks. Whilst they benefit from greater security, they lose out to potentially rapid growth and huge returns.
Examples of Preferred Stock
Preferred stock, also known as ‘preference shares’ are issued by the company to meet its immediate needs. These include callable, convertible, cumulative, and participatory shares. Each provides the company and investor with different benefits and drawbacks. In turn, some are preferred by companies at different stages of its development.
Callable Preferred Shares
Callable shares are where the issuing company has the ability to buy these back at a fixed price in the future. This has a huge benefit for the company because it is able to react to changes in the interest rate and act accordingly. For example, it may be paying a 5 percent dividend.
However, if the interest rates fall, they may be able to offer a rate of 3 percent instead. In turn, the company can exercise its option to buy the shares back, thereby eliminating its 5 percent a year obligation. It can then re-issue the same shares at 3 percent, thereby saving the additional dividend payment.
Now the immediate question is why would investors accept such terms? The answer is in the fact that these types of preferred stock are generally issued by big corporations. Dividend payments are more or less guaranteed as these companies are well established. There’s also less risk from the company going under than some developing alternative. And the comparative common stock is unlikely to see rapid equity growth. So all in all, it offers a relatively safe investment that pays relative to the risk involved.
Convertible Preferred Shares
Convertible shares allow the investor the ability to exchange their preferred stock for common stock. This allows the investor to benefit from any large gains in the firms market value as common shares increase in price.
For example, let’s say the issuing firm allows a convertible ratio of one preferred stock to four common stock. The initial preferred stock was bought for $100. At the time of purchase, the common stock was valued at $25. This would mean that should the investor exercise their option, they would gain nothing.
Should the common stock price increase to say $30, this would mean the investor could convert their $100 preferred stock into $120 worth of common stock. Meaning a 20 percent return on investment.
The only issue with such stock is that they are generally issued by small, early development companies. A large number of which will fail, whilst a small number will go on to succeed. In turn, this makes it a risky investment. Whilst there is scope for exponential growth, there is a greater risk of a complete loss of investment.
Cumulative Preferred Shares
Cumulative preferred shares have a clause which protects the investor in the event that the firm cannot pay its dividends. Instead, any unpaid dividends are rolled over into subsequent years. For example, an investor has a preferred stock which has a yield of 5 percent which works out at $100. If the firm is unable to pay that for 3 consecutive years, the investor would by due $400 in year 4.
This type of preferred stock resolves one of the biggest drawbacks – where firms miss dividend payments. Instead, those payments are guaranteed assuming the firm returns to profit. However, this benefit doesn’t come without a cost. These cumulative shares often have lower yield rates as they represent a lower risk than comparative preferred shares.
Participatory Preferred Shares
Participatory preferred stocks provide shareholders with dividends over and above the issued price. For example, an investor may purchase a preferred stock with a dividend yield of 5 percent. Those who have a participatory preferred share, they benefit from a larger yield when the company exceeds specific financial goals.
These financial goals might include a certain level of profit. For instance, over $1 million would trigger a dividend yield increase to 6 percent. This allows the investors to benefit alongside the firms higher level of profitability.
Generally speaking, this type of preferred share will offer lower rates than non-participatory shares. As investors will have the ability to claim higher returns, this benefit is balanced out through lower average returns.
Preferred Stock vs Common Stock
A preferred stock acts much like a common stock in a number of ways. They are both sold via the stock market and represent ownership of the company. However, the similarities end there. Whilst common stock owners have the ability to vote on companies decision making, preferred stock owners have no say.
The lack of voting rights is one of the factors that some business like about preferred shares. They are able to conduct their business with little interference.
Although preferred and common stock may receive dividends, preferred shares receive a fixed amount throughout the year. This amount is pre-determined from the initial issuance. By contrast, common stock dividends can increase or decrease at the companies will.
Another key difference is that common stock holders will benefit from greater price fluctuations in the share price. Common stocks can increase rapidly, allowing owners to benefit. Yet preferred stocks don’t increase much more than their issuance else the company will purchase them back.
On top of that, preferred stock owners will receive beneficial treatment in the event the business collapses. They will receive payment of their investment before any common stock owners.
|Preferred Stock||Common Stock|
|Sold on stock market||Sold on stock market|
|Ownership of company||Ownership of company|
|No voting rights||Voting rights|
|Fixed dividend payments||Variable dividend payments|
|Limited stock price movement||Stock price can increase or decrease significantly|
|Fewer buyers and sellers||Large number of buyers and sellers|
|Preferred treatment in face of liquidation||Last in line during liquidation|
|Company can purchase back at any time for a set fee||Company can only purchase back at the market rate or more|
Preferred Stock vs Bonds
Preferred stocks have a number of similarities to bonds. For instance, both receive a fixed payment each year and both have no real say over how the company is run. These assets can also be redeemed by the issuer at any point, meaning they can re-purchase at a pre-agreed price. Yet there are also many differences.
Such differences include the fact that preferred stock represents actually ownership of the company, whilst bonds are debt. Although preferred stock owners don’t have voting rights, they still own part of the company.
Bond owners benefit from preferential treatment during liquidation. This means that should the company go bankrupt, it would have a higher claim to outstanding assets than preferred shareholders. In turn, this lowers the potential risk of a lost investment. As a result, bonds tend to offer lower rates of return due to this fact.
|Preferred Stock||Common Stock|
|Fixed payment each year||Fixed payment each year|
|Lack of voting rights||Lack of voting rights|
|Issuers can buy back the stock||Issuers can buy back the bond|
|Potentially convertible to common stock||Potentially convertible to common stock|
|Inferior claim to assets during liquidation||Superior claim to assets during liquidation|
|Seen as higher risk than bonds||Seen as lower risk than preferred stock|
|Higher yield due to higher risk||Lower yield due to lower risk|
|Dividend payments liable for dividend tax||Interest payments liable for income tax|
Preferred stocks have a fixed dividend rate which doesn’t vary and is due each year assuming the firm makes a profit. By contrast, common stockholders are never guaranteed a dividend payment. However, preferred stock owners do not receive voting rights unlike common stock owners.
Preferred stocks offer an almost guaranteed dividend return each year and present a lower risk profile than a common stock.
A preferred stock is a mix between a bond and a stock. It is readily traded on the stock market and represents ownership of the company. However, it owners also benefit from regular dividend payments that are fixed. When an investor purchases a preferred stock, they will receive a fixed dividend rate until it either expires or the company purchases the stock back.
The main downside of a preferred stock is that it doesn’t offer the same potential equity returns as a common stock. It has no relationship with the firms common stock, so when the company does well it won’t benefit from increases in the share price. Instead, its price acts much like a bond and fluctuates alongside the interest rate.
Paul Boyce is an economics editor with over 10 years experience in the industry. Currently working as a consultant within the financial services sector, Paul is the CEO and chief editor of BoyceWire. He has written publications for FEE, the Mises Institute, and many others.