What Is Preferred Stock?
Preferred stock, or preference shares, is a type of equity security that represents ownership in a company, similar to common stock, but with distinct features regarding dividends and asset claims. It belongs to the broader financial category of capital structure, often viewed as a hybrid securities because it combines characteristics of both common stock and bonds. Holders of preferred stock typically receive fixed dividend payments before common stockholders and have a preferential claim on a company's assets in the event of liquidation. Unlike common stock, preferred stock usually carries no voting rights.
History and Origin
The concept of preferred stock emerged in the United States in the mid-19th century, with the Pennsylvania Railroad Company often cited as one of the first issuers. These early preference shares were designed to provide investors with a more stable income stream through higher dividend payouts and a priority claim on company assets during financial distress, offering a compromise between traditional equity and debt financing.10 As large public utilities and transportation companies sought capital in the early 20th century, preferred stock became an increasingly popular investment vehicle.9 Its structure provided a means for companies to raise capital while offering investors a potentially more secure investment compared to pure common equity, laying the groundwork for its role in modern corporate finance.
Key Takeaways
- Preferred stock typically offers fixed dividend payments, which are paid out before any common stock dividends.
- In the event of a company's liquidation, preferred stockholders have a higher claim on assets than common stockholders, but their claims are subordinate to those of bondholders.
- Unlike common stock, preferred stock generally does not grant voting rights, meaning preferred shareholders have little to no say in corporate governance.
- Preferred stock combines features of both equity and fixed income securities, making it an attractive option for income-focused investors.
- The price of preferred stock is often less volatile than common stock due to its fixed dividend and preferential claims.
Formula and Calculation
The valuation of perpetual preferred stock, which has no maturity date, can be approximated using a dividend discount model, similar to a perpetuity. The formula calculates the theoretical price based on its fixed dividend payment and the required rate of return or yield an investor expects.
Where:
- Annual Dividend Payment = The fixed annual dividend paid per share of preferred stock.
- Required Rate of Return = The return an investor expects to receive from the preferred stock, reflecting its risk.
For instance, if a preferred stock pays an annual dividend of $2.50 per share and investors require a 5% rate of return, its theoretical value would be ( $2.50 / 0.05 = $50.00 ). This formula provides a basic framework for valuing preferred stock that pays a constant dividend indefinitely.
Interpreting Preferred Stock
Interpreting preferred stock involves understanding its unique position within a company's capital structure and its implications for both issuers and investors. For investors, preferred stock is often seen as an income-generating asset, appealing due to its generally predictable dividends. The "preferred" aspect signifies that these dividends must be paid before any common stock dividends, and in a liquidation scenario, preferred shareholders are paid before common shareholders. This preferential treatment offers a degree of safety not found in common stock.
However, the fixed nature of preferred stock dividends means that preferred shareholders typically do not participate in the company's significant growth in the same way common stockholders might through capital appreciation. For companies, issuing preferred stock can be a way to raise capital without diluting the voting power of existing common stock holders, or taking on additional debt. Its interpretation, therefore, hinges on balancing income stability and priority with limited growth potential and control.
Hypothetical Example
Consider "Tech Innovations Inc." which decides to issue new preferred stock to fund a research and development project. Each share of their new preferred stock has a par value of $100 and pays an annual fixed dividend of 5% of its par value.
Here's how it would work:
- Dividend Calculation: The annual dividend per preferred share is 5% of $100, which equals $5. This dividend is typically paid quarterly, so an investor would receive $1.25 per share every three months.
- Priority of Payment: If Tech Innovations Inc. has a profitable quarter, the $1.25 dividend per preferred share must be paid out before any dividends can be distributed to holders of Tech Innovations' common stock.
- Liquidation Scenario: Suppose Tech Innovations Inc. faces severe financial difficulties and undergoes liquidation. After all creditors and bondholders are paid, preferred stockholders would receive their share of the remaining assets, up to their par value, before common stockholders receive anything.
This example illustrates the fixed income stream and priority features that are central to preferred stock.
Practical Applications
Preferred stock finds various practical applications across financial markets and corporate finance. One significant area is in the financial sector, where banks and other financial institutions frequently issue preferred stock as a component of their regulatory capital. This allows them to meet capital adequacy requirements while offering investors a high yield security.8,7 For instance, the Federal Reserve's stress tests on banks can influence the stability of dividends for financial sector preferred stocks, highlighting their sensitivity to regulatory oversight.6
Furthermore, preferred stock can be used by companies seeking to raise capital without diluting the voting power of their existing common stock holders, as preferred shares typically do not come with voting rights. Investors, on the other hand, might incorporate preferred stock into their portfolios for its income-generating potential, viewing it as a bridge between traditional fixed income and equity asset classes.5 Issuers also benefit from the flexibility to defer preferred dividends without triggering default, unlike debt obligations. An SEC filing for a "fixed rate cumulative perpetual preferred stock" details the specific terms and conditions under which these securities are issued and governed, demonstrating their structured nature in public markets.4
Limitations and Criticisms
Despite their advantages, preferred stocks come with certain limitations and criticisms that investors should consider as part of a thorough investment analysis. A primary concern is their sensitivity to interest rate changes. Because preferred stock typically offers a fixed dividend, its market value tends to decline when interest rates rise, as newer issues offer more attractive yields.3 This exposes preferred stock investors to interest rate risk, similar to bondholders.
Another significant drawback is the lack of voting rights for most preferred shareholders. This means they have little to no control over the company's management or strategic decisions, even if the company's performance deteriorates. Furthermore, preferred stocks generally have less price appreciation potential compared to common stock, as their upside is often capped by their fixed dividend and potential call provisions, which allow the issuer to repurchase the shares at a predetermined price. Liquidity can also be a concern, as the market for preferred stock is often less robust than for common equities, potentially leading to higher transaction costs and wider bid-ask spreads.2 While the preferential treatment in liquidation offers some protection, preferred shareholders are still subordinate to all creditors, meaning their claims would only be satisfied after all debt obligations are met.1
Preferred Stock vs. Common Stock
The fundamental difference between preferred stock and common stock lies in their respective rights and characteristics. Common stock represents basic ownership in a company, typically granting voting rights that allow shareholders to elect the board of directors and influence corporate policy. Common stockholders are residual claimants, meaning they are last in line to receive assets during liquidation and receive dividends only after preferred shareholders have been paid. While common stock offers unlimited upside potential through capital appreciation, its dividend payments are variable and not guaranteed.
In contrast, preferred stock does not usually carry voting rights. Its "preference" comes from its higher claim on assets in liquidation and its priority in receiving fixed dividend payments. These dividends are often cumulative, meaning any missed payments must be paid to preferred stockholders before common stockholders can receive future dividends. Preferred stock typically exhibits lower price volatility than common stock but generally has limited capital appreciation potential. The confusion often arises because both are forms of equity ownership, but they cater to different investor objectives and offer distinct risk-reward profiles within a company's capital structure.
FAQs
What does "preferred" mean in preferred stock?
The term "preferred" indicates that this class of shares has preferential rights over common stock. This typically means preferred stockholders receive their dividends before common stockholders and have a higher claim on the company's assets in the event of liquidation.
Does preferred stock have voting rights?
Generally, no. Most preferred stock issues do not come with voting rights, unlike common stock. This means preferred shareholders usually have no say in the company's management or strategic decisions.
Are preferred stock dividends guaranteed?
While preferred stock dividends are typically fixed and have priority, they are not legally guaranteed in the same way interest payments on bonds are. A company's board of directors must declare the dividend. However, many preferred shares are cumulative, meaning that any unpaid dividends accrue and must be paid before any common stock dividends can be distributed.
How does preferred stock compare to bonds?
Preferred stock shares some similarities with bonds, such as fixed payments (dividends for preferred stock, interest for bonds) and sensitivity to interest rates. However, preferred stock is an equity security, representing ownership, whereas a bond is a debt instrument. In liquidation, bondholders have a higher claim on assets than preferred stockholders.
Why do companies issue preferred stock?
Companies issue preferred stock to raise capital without diluting the voting power of existing common stock holders. It can also be an attractive financing option when traditional debt financing is expensive or not feasible, or to fulfill specific regulatory capital requirements, particularly in industries like banking.