You may have heard about preferred stock (or preferred share) before, but exactly how are they different from common stock (or ordinary share). Preferred stock is a another form of ownership in a company. Preferred stock is treated differently than common stock and has significant differences in the type of relationship the shareholder has with the company. Is it the right type of ownership for you? Let’s find out.
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What is Preferred Stock?
Companies have several options to finance operations or to raise significant amounts of capital for expansion. Most investors have heard of the two main categories: by issuing debt (bonds) or by selling equity (stock). By issuing bonds the company does not dilute the share of the current shareholders because money is borrowed at a set interest rate and returned to the bondholders at the end of the term. Bondholders get paid first if the company is liquidated because of the debt that is owed.
When a company issues new common shares the current shareholders’ overall share in the business is diluted. Common stockholders also receive voting rights as to how the company is run. Common shares sometimes include a dividend that can be changed by the firm. Additionally, common shares are dead last when it comes to being repaid for their investment in the company if the firm goes bankrupt or is liquidated. You trade risk for the right to appreciation of the shares in the company.
In between these two categories lies preferred stock. Preferred shares have similarities with both bonds and common shares. Preferred stockholders are paid a fixed dividend before any dividend is paid to common shareholders, similar to bondholders receiving a fixed interest rate from the firm. Preferred shares also have the chance to appreciate in value which gives the preferred shareholder a mix of a bond-like investment (with the fixed dividends) as well as growth through share appreciation.
How is Preferred Stock Different from Common Stock?
Preferred shareholders make a trade by investing in preferred shares over common stock. By taking a fixed dividend that gets paid before the common shareholders dividend (or in the event of a liquidation), they give up the right to vote in how the company is run. Additionally common shares increase (and decrease) in value a lot faster than preferred shares because of the lack of a bond-like component in the shares. If you have common shares in a research and development company that has a big breakthrough the common shares might triple in value while the preferred shares only go up a handful of points. You are trading risk for security and reward for consistent payouts.
Types of Preferred Stock
There are many types of preferred stock and occasionally the types can be mixed. Here are three of the most common types of preferred shares:
A majority of preferred stock is cumulative preferred stock. This means that any dividend payments that are withheld must eventually be paid out (unless of course the company goes under). If you hold 1,000 preferred shares and the company owes you a $1 dividend in the third quarter that goes unpaid, in the fourth quarter (or at some other point in the future) you must be paid the $1,000 in dividends you are owed.
You may have heard the phrase “call the shares” with options trading. With callable preferred stock the company issues the shares with a specific date and price that the shares can be called back to the company. You might invest in preferred shares today that can be called back in two years. You would receive the fixed dividend and any growth in the shares during that time. At the appointed date the company could call the shares back and pay you a set price per share value for the shares you hold.
Convertible preferred shares give the shareholder the option to trade your preferred shares in for a set number of common stock. This option is usually after a set date in the future. You would receive the fixed dividend before the conversion and then have the opportunity to exchange the shares for common stock if you were expecting shares to go dramatically higher in the future.
Risks of Preferred Stocks
Preferred shares fall in between pure stocks and pure bonds by giving investors a little bit of both with their investment. However, there are some risks to be aware of:
Interest rate risk
Just like bonds are sensitive to interest rate changes, the fixed dividend paid by preferred shares is impacted as well. If your preferred shares pay a 5% fixed dividend and interest rates as a whole rise, you would need to discount the value of your shares in order to sell them to another investor in the future. If you were happy with the fixed dividend you would keep it, otherwise you would lose some per share value if you went to sell the shares.
Loss of growth due to fixed dividend
Receiving a fixed dividend payment like you are a bondholder is nice, but it might pale in comparison to the growth of the value of common stock shares. This is the ultimate investing test: do you want…
- pure fixed payments that get first rights to the company’s assets in a liquidation (bonds),
- the volatility and risk of common shares that could end up worthless or worth much more than you paid for them, or
- something in the middle that provides some income and some opportunity for growth?
Dividend is not guaranteed
A third key aspect to be aware of with preferred shares is while you are in front of common shareholders in line for the company’s assets and dividend payments, you’re not that much further ahead. With preferred shares your dividend is fixed and is paid after bondholders are paid. If the company runs into a significant cash crunch, your dividend is not guaranteed to be paid. The board of directors can decide to suspend preferred shareholders’ dividend in order to keep the cash for operations. You would miss the dividend payment and if the company recovers the dividends would eventually be paid to you (unlike common shareholders). However, if the firm is in bad shape and doesn’t recover, you end up behind bondholders when it comes to receiving any value from the sale of the firm’s assets.
No voting rights
Common shareholders vote on key aspects of how the company is run. Preferred shareholders have no voting rights. For the average investor holding a very small percentage of the total amount of shares outstanding this doesn’t mean much. But for investment firms or institutions holding significant number of shares, having common stock means you can help dictate what the company does. Preferred shareholders simply have to accept what decisions the company, its board, and the common shareholders make.
Kevin Mulligan is a debt reduction champion with a passion for teaching people how to budget and stay out of debt. He’s building a personal finance freelance writing career and has written for RothIRA.com, Discover Bank, and many others.