First preferred stock

What Is Preferred Stock?

Preferred stock, often referred to as preferred shares or preference shares, is a type of equity security that represents ownership in a corporation and typically pays fixed dividends. It is generally considered a hybrid security, blending characteristics of both common stock and bonds, positioning it within the broader field of corporate finance and securities. Holders of preferred stock have a priority claim over common shareholders on the company's assets and earnings, particularly concerning dividend payments and in the event of liquidation.¹⁸

History and Origin

The concept of preferred stock emerged in the 19th century as companies sought alternative ways to raise capital while offering investors more security than common shares. While preference shares were first introduced in the 1830s by some transportation companies, the first preferred stock in the United States is often attributed to the Pennsylvania Railroad Company in the mid-19th century.¹⁶, ¹⁷ These early issuances aimed to provide investors with a more predictable income stream and a priority claim on company assets, setting them apart from ordinary equity. Preferred stock became more widely adopted by large public utilities and transportation companies in the early 20th century as a means of financing growth.¹⁵

Key Takeaways

• Preferred stock typically offers fixed dividend payments, which must be paid before any dividends are issued to common shareholders.¹⁴
• In the event of a company's liquidation, preferred stockholders have a higher claim on the company's assets than common stockholders, though they are subordinate to bondholders.¹³
• Unlike common stock, preferred stock generally does not carry voting rights, meaning preferred shareholders have less influence over corporate governance.
• Preferred stock can be callable, allowing the issuer to repurchase the shares, or convertible, permitting conversion into common stock.¹²
• Historically, preferred stock has offered higher yields compared to some other asset classes, though with its own set of risks.¹¹

Formula and Calculation

The dividend yield for preferred stock is calculated by dividing the annual preferred dividend by the stock's current market price. This calculation helps investors assess the yield generated relative to the investment.

For example, if a preferred stock pays an annual dividend of $2.00 per share and its current market price is $50.00, the dividend yield would be 4%. This metric is crucial for investors focused on regular income, similar to how interest rates are evaluated for debt instruments.

Interpreting the Preferred Stock

Interpreting preferred stock involves understanding its dual nature as both an equity and a debt-like instrument. The fixed dividend payments make preferred stock attractive to income-focused investors, as they provide a more predictable cash flow compared to the variable dividends of common stock.¹⁰ When evaluating preferred stock, investors often look at the stated dividend rate relative to prevailing interest rates and the creditworthiness of the issuing company. A higher dividend yield might compensate for perceived higher risk, while a lower yield from a highly stable company may still be appealing for its reliability. The absence of voting rights for preferred stockholders means their influence on corporate decisions is limited, a key consideration for those interested in governance.

Hypothetical Example

Imagine "GreenTech Innovations Inc." issues 1 million shares of a new preferred stock with a par value of $25 per share, offering a fixed annual dividend rate of 5%. This means each preferred share will pay an annual dividend of $1.25 ($25 par value × 0.05). If an investor purchases 100 shares of this preferred stock, they would expect to receive $125 in annual dividends (100 shares × $1.25/share).

Now, suppose GreenTech Innovations faces a challenging year and decides not to pay any dividends on its common stock. Due to the preferential nature of preferred stock, GreenTech would still be obligated to pay the $1.25 per share dividend to its preferred shareholders before any dividends could be distributed to common shareholders in future periods, especially if the preferred stock is cumulative. This highlights the income priority preferred stock offers.

Practical Applications

Preferred stock is utilized in various financial contexts, reflecting its unique position in a company's capital structure. Companies, particularly those in the financial sector like banks, have historically issued preferred stock as a component of their regulatory capital (e.g., Tier 1 capital), though specific regulations regarding this use have evolved. T⁹his provides a stable source of funding without diluting common equity ownership or incurring the fixed interest obligations of traditional debt.

In the world of venture capital and private equity, preferred stock is a common financing instrument used to balance the interests of investors and founders. I⁸nvestors often receive preferred shares with special rights, such as liquidation preferences, which ensure they receive their initial investment back before common shareholders in the event of an acquisition or sale. F⁷or investors, preferred stock can be a strategic choice for income generation and risk mitigation, particularly when seeking steady cash flow with a higher claim on assets than common shares.

⁶## Limitations and Criticisms

Despite their advantages, preferred stock instruments come with limitations and criticisms. A primary drawback for investors is the general lack of capital appreciation potential compared to common stock. Since preferred dividends are typically fixed, preferred shareholders do not usually participate in the growth of a company's earnings beyond their stated dividend. Additionally, most preferred stocks do not carry voting rights, which means holders have no say in corporate decisions or electing the board of directors.

Preferred stock can also be susceptible to interest rate risk; when market interest rates rise, the fixed dividends of existing preferred stock may become less attractive, causing their market price to fall. During periods of economic instability or financial crisis, preferred stock can experience significant drawdowns, especially those issued by financial institutions. W⁵hile typically less volatile than common stocks during normal market conditions, they are not immune to market downturns and credit risk deterioration. F⁴urthermore, companies may choose to suspend preferred dividend payments, particularly if the stock is non-cumulative, or if financial distress makes it difficult, though this is rare as it impacts a company's ability to pay common stock dividends.

², ³## Preferred Stock vs. Common Stock

The distinction between preferred stock and common stock is fundamental to understanding a company's capital structure. While both represent ownership, their rights and features differ significantly.

Confusion often arises because both are forms of equity. However, the preference for dividends and assets, coupled with the lack of voting power, clearly sets preferred stock apart. Investors choose between them based on their priorities: income and stability (preferred) versus growth and control (common).

FAQs

What is the primary advantage of preferred stock for investors?

The primary advantage of preferred stock for investors is the receipt of regular, fixed dividends that take precedence over common stock dividends. This provides a more predictable income stream.

Do preferred stockholders have voting rights?

Generally, preferred stockholders do not have voting rights. This means they cannot vote on corporate matters or elect the board of directors, unlike most common stock shareholders.

What happens to preferred stock if a company goes bankrupt?

In the event of a company's bankruptcy or liquidation, preferred stockholders have a priority claim on the company's assets over common stockholders. However, their claims are still subordinate to those of bondholders and other creditors.

Is preferred stock more like a stock or a bond?

Preferred stock is often considered a hybrid security because it shares characteristics of both. Like bonds, it typically offers fixed payments and has a priority claim. Like stock, it represents ownership (equity) in a company and is recorded on the balance sheet as equity.

Can preferred stock dividends be suspended?

Yes, companies can suspend preferred dividend payments, especially if facing financial difficulties. However, for cumulative preferred stock, any missed dividends accumulate and must be paid before any dividends can be issued to common shareholders. For non-cumulative preferred stock, missed payments are typically forfeited.¹