Cumulative preferred stock

What Is Cumulative Preferred Stock?

Cumulative preferred stock is a type of preferred stock that guarantees all scheduled dividends, including any that were missed in previous periods, must be paid to shareholders before any dividends can be distributed to common stock holders. This feature provides a layer of investor protection by ensuring that preferred shareholders accumulate a claim to unpaid dividends, which are recorded as arrears. It falls under the broad financial category of Corporate Finance, specifically as an equity security within a company's capital structure. Unlike common stock, cumulative preferred stock typically does not carry voting rights but offers more predictable investment income through fixed dividend payments.

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 issuing the first such shares. These early forms of preferred stock were designed to attract investors by offering a higher, more stable return on investment and a superior claim on company assets compared to common shares. The "cumulative" feature evolved as a mechanism to further enhance the security and appeal of these instruments to investors seeking reliable income streams. By ensuring that missed dividend payments would accrue and be settled before any distributions to common shareholders, cumulative preferred stock addressed concerns about the consistency of dividend payments, particularly during periods of corporate financial stress. This structure aimed to bridge the gap between fixed-income debt instruments, like corporate bonds, and traditional equity.⁶

Key Takeaways

• Cumulative preferred stock entitles its holders to receive all past unpaid dividends before common shareholders receive any dividends.
• These shares typically offer fixed dividend payments, making them attractive to income-focused investors.
• In the event of liquidation, cumulative preferred shareholders have a higher claim on company assets than common shareholders, but are subordinate to bondholders.
• Unlike common stock, cumulative preferred stock usually does not grant voting rights.
• The cumulative feature provides greater dividend reliability compared to non-cumulative preferred stock, where missed dividends are forfeited.

Formula and Calculation

The valuation of a preferred stock, including cumulative preferred stock, often uses a perpetual dividend discount model, assuming fixed, ongoing dividend payments. While the cumulative feature doesn't alter the core valuation formula itself, it significantly enhances the certainty of receiving those dividends, which can influence the required rate of return (or discount rate) investors apply.

The basic formula for valuing a preferred stock as a perpetuity is:

$P = \frac{D}{r}$

Where:

• ( P ) = Price of the preferred stock
• ( D ) = Annual fixed dividends per share
• ( r ) = Required rate of return on investment (discount rate)

For cumulative preferred stock, if the company misses a dividend payment, that payment, along with any subsequent missed payments, is added to an arrears account. When the company resumes dividend payments, all accumulated arrears must be paid in full before common shareholders receive anything. This doesn't change the calculation of one dividend payment, but it mandates the payment of multiple dividends if they were missed.

Interpreting Cumulative Preferred Stock

Interpreting cumulative preferred stock involves understanding its hybrid nature and its position within a company's capital structure. For investors, the cumulative feature signals enhanced investor protection regarding dividend payments. If a company experiences financial difficulties and cannot pay its preferred dividends, these unpaid amounts accrue. This accumulation means that a company must prioritize the payment of all accumulated preferred dividends before it can distribute any dividends to its common stock holders. This is a significant advantage for preferred shareholders, providing more predictable investment income over time, even if there are intermittent cash flow issues for the issuing company.

Hypothetical Example

Imagine ABC Corp. has issued 1,000 shares of cumulative preferred stock with a par value of $100 and an annual dividend rate of 5%. This means each share is entitled to an annual dividend of $5 (5% of $100).

• Year 1: ABC Corp. earns a profit and pays the preferred dividends of $5 per share.
• Year 2: Due to an unexpected economic downturn, ABC Corp. incurs a loss and decides not to pay any dividends to its shareholders. Because the preferred stock is cumulative, the $5 dividend for Year 2 is not lost; instead, it goes into arrears. The total arrears are now $5 per share.
• Year 3: ABC Corp. has a strong recovery and generates significant profit. Before it can declare any dividend for its common stock holders, it must first pay the preferred shareholders their current year's dividend ($5) plus the accumulated arrears from Year 2 ($5). Therefore, cumulative preferred shareholders receive a total of $10 per share ($5 from Year 2 + $5 from Year 3) in Year 3. Only after these payments are made can ABC Corp. consider paying dividends to its common shareholders.

This example illustrates how the cumulative feature protects the preferred shareholder's right to receive all promised dividends, even if payment is delayed.

Practical Applications

Cumulative preferred stock plays a role in various aspects of corporate finance and investing. For companies, issuing cumulative preferred stock can be a form of equity financing that attracts investors seeking predictable income without diluting the voting control of common shareholders. It sits between debt financing and common equity in a company's capital structure, offering a hybrid financing solution.

From an investor's perspective, cumulative preferred stock is often attractive to those looking for stable fixed income and potentially higher yields than corporate bonds, with greater certainty of dividend payment compared to non-cumulative preferred stock. These securities are commonly found in the portfolios of institutional investors, pension funds, and individual investors focused on generating consistent investment income. Regulatory bodies, such as the U.S. Securities and Exchange Commission (SEC), also have specific disclosure requirements for preferred stock, particularly redeemable preferred stock, influencing how companies report these securities on their financial statements.

Limitations and Criticisms

While cumulative preferred stock offers several advantages, it also comes with limitations and criticisms. A primary drawback for investors is the typical absence of voting rights, meaning preferred shareholders have no say in corporate governance or strategic decisions, unlike common stock holders.⁵ Furthermore, the fixed nature of preferred dividends means that preferred shareholders do not participate in the potential for higher earnings or capital appreciation if the company's profitability significantly increases. The potential for price appreciation in cumulative preferred stock is generally limited, as their values are often more influenced by changes in interest rates than by company performance.⁴

Another criticism is that, while preferred shares have priority over common shares in liquidation, they are subordinate to all debt holders, including corporate bonds. In a bankruptcy scenario, there might be insufficient assets to satisfy preferred shareholders after creditors are paid.³ From the perspective of the issuing company, preferred stock can be a more expensive form of capital than issuing debt financing because preferred dividends are generally not tax-deductible for the corporation, unlike interest payments on bonds.² Additionally, many preferred shares are callable, allowing the issuer to repurchase them at a predetermined price after a certain date, which can limit the investor's long-term gains if the stock is called when interest rates fall.¹

Cumulative Preferred Stock vs. Non-cumulative Preferred Stock

The key distinction between cumulative preferred stock and non-cumulative preferred stock lies in the treatment of missed dividend payments. For cumulative preferred stock, any scheduled dividends that a company fails to pay are recorded as arrears and accrue. These accumulated unpaid dividends must be fully settled before the company can distribute any dividends to its common stock holders. This feature provides a stronger assurance of eventual dividend receipt for the cumulative preferred shareholders.

In contrast, with non-cumulative preferred stock, if a company misses a dividend payment, that payment is simply forfeited. The shareholders of non-cumulative preferred stock have no claim to those missed dividends, and the company is under no obligation to pay them in the future. This makes non-cumulative preferred stock a riskier investment income option compared to its cumulative counterpart, as the stream of income is less certain during periods of financial distress for the issuing company.

FAQs

1. What happens if a company misses a dividend payment on cumulative preferred stock?

If a company misses a dividend payment on cumulative preferred stock, the unpaid amount accumulates and is recorded as arrears. The company must pay all accumulated arrears, in addition to any current dividends due, to the cumulative preferred shareholders before it can pay any dividends to its common stock holders.

2. Do cumulative preferred stockholders have voting rights?

Typically, cumulative preferred stockholders do not have voting rights. Their primary benefit is the priority claim to dividends and assets in liquidation, rather than influence over corporate management.

3. Is cumulative preferred stock considered debt or equity?

Cumulative preferred stock is generally considered a hybrid security, possessing characteristics of both debt financing (like fixed dividend payments, similar to bond interest) and equity financing (representing ownership in a company, though with limited rights). It is part of the company's [capital structure].

4. Are cumulative preferred stock dividends guaranteed?

While the cumulative feature provides strong assurance that dividends will eventually be paid, they are not strictly "guaranteed" in the same way that bond interest payments are. A company is only obligated to pay dividends if it has sufficient earnings or declares them. However, if payments are missed, the cumulative feature ensures they must be paid later, once the company is able to do so, before common shareholders receive anything.

5. Why would a company issue cumulative preferred stock?

Companies issue cumulative preferred stock to raise capital without diluting the voting power of common stock holders. It can also be an attractive way to secure equity financing from investors who prioritize stable investment income and predictable returns over potential capital appreciation or voting rights.