What Is Preferred Stock?
Preferred stock represents a class of equity ownership in a company that grants its shareholders certain preferential rights over common stock holders. This type of security is a cornerstone of corporate finance, blending characteristics of both debt and equity instruments, often referred to as a hybrid security. Preferred stock typically pays a fixed dividend and holds a higher claim on a company's assets and earnings than common stock, especially during a liquidation event. Due to these attributes, preferred stock is often categorized under fixed income investments.
History and Origin
Preferred stock evolved as a versatile financial instrument designed to attract investors seeking more predictable income streams than common stock, while offering companies an alternative capital-raising tool without diluting common shareholders' voting power. Its hybrid nature, combining elements of bond and equity, has made it a useful component in corporate capital structures, particularly for certain industries like financial institutions and utilities. Over time, preferred stock has been adapted with various features such as convertibility and callability to meet diverse financing and investment needs.
Key Takeaways
- Preferred stock offers preferential treatment to its holders regarding dividend payments and asset claims during liquidation.
- Unlike common stock, preferred stock typically does not carry voting rights.
- Dividends on preferred stock are often fixed, making them attractive to income-focused investors.
- In the event of bankruptcy, preferred stockholders have priority over common stockholders but are subordinate to bondholders.
- Many preferred shares include a call option, allowing the issuer to repurchase them at a predetermined price.
Formula and Calculation
The valuation of a perpetual preferred stock, which has no maturity date, is calculated similarly to a perpetuity. The market value of preferred stock can be estimated using the following formula:
Where:
- Annual Preferred Dividend = The fixed annual dividend payment per share.
- Required Rate of Return = The return an investor expects to receive for holding the preferred stock, reflecting its risk and the prevailing interest rates.
For instance, if a preferred stock pays an annual dividend of $2 per share and investors require a 5% rate of return, its theoretical value would be ( \frac{$2}{0.05} = $40 ). This formula highlights how the stock's price is inversely related to the required rate of return or yield.
Interpreting the Preferred Stock
Preferred stock is often interpreted as a blend of equity and fixed income because it combines features of both. Like a bond, it typically pays a fixed dividend based on its par value or coupon rate, offering a predictable income stream. However, like common stock, it represents ownership in a company and does not have a maturity date. Its price sensitivity to interest rate changes is similar to bonds, where rising rates generally cause preferred stock prices to fall and vice versa.
Investors often assess preferred stock based on its dividend yield relative to other fixed-income alternatives and its position in the capital structure. The specific features, such as whether dividends are cumulative dividend (missed dividends accrue and must be paid later) or non-cumulative, also significantly influence its interpretation and attractiveness to investors.
Hypothetical Example
Consider XYZ Corp. which issues 1 million shares of preferred stock with a par value of $25 per share and an annual dividend rate of 6%.
- Annual Dividend per share: $25 (par value) * 0.06 (dividend rate) = $1.50 per share.
- Total Annual Dividend Payout: $1.50/share * 1,000,000 shares = $1,500,000.
If XYZ Corp. has a profitable year, it must pay the $1.50 per share dividend to its preferred stockholders before it can distribute any dividends to its common stockholders. If the preferred stock is callable and interest rates decline significantly, XYZ Corp. might exercise its call option to redeem the existing preferred stock and issue new preferred stock at a lower dividend rate, reducing its financing costs.
Practical Applications
Preferred stock serves several practical applications for both companies and investors. For companies, it's a way to raise capital without diluting the voting control of common shareholders or incurring the fixed interest obligations of traditional debt. It can also enhance a company's balance sheet by counting as equity, which is beneficial for regulatory capital requirements, particularly for financial institutions.8
For investors, preferred stock offers a consistent income stream through its regular dividend payments, making it appealing to those seeking fixed income or portfolio diversification. It is often found in the portfolios of institutions and individuals prioritizing income generation over capital appreciation. For example, in July 2025, MicroStrategy, Inc. announced the closing of a significant initial public offering of its Series A Perpetual Stretch Preferred Stock, highlighting its use as a capital-raising tool.7 Companies often provide detailed information about their preferred stock offerings in public filings, such as prospectus supplements submitted to the U.S. Securities and Exchange Commission (SEC).6
Limitations and Criticisms
While preferred stock offers distinct advantages, it also carries limitations and criticisms for investors. One significant drawback is the typically limited potential for capital appreciation, unlike common stock which can see substantial price growth alongside company performance.5 The primary return for preferred stockholders comes from the fixed dividend, meaning they do not directly participate in the company's residual profits.4
Another major criticism is related to call option risk. Many preferred shares are callable, allowing the issuing company to repurchase the stock at a predetermined price after a certain date. This feature becomes particularly disadvantageous for investors when interest rates fall, as the company may call back higher-yielding preferred shares, forcing investors to reinvest in a lower-rate environment.3
Furthermore, preferred stock can present higher default risk than high-yield bonds and exhibit significant volatility during market downturns, despite often being perceived as safer than common stock.2 For the issuing company, preferred stock dividends are generally not tax-deductible, unlike interest payments on debt, making it a more expensive form of capital for strong credits.1
Preferred Stock vs. Common Stock
The distinction between preferred stock and common stock is crucial for understanding their respective roles in a company's capital structure and their appeal to different types of investors.
| Feature | Preferred Stock | Common Stock |
|---|---|---|
| Voting Rights | Generally none or limited | Typically includes voting rights |
| Dividend | Fixed, preferential, often cumulative dividend | Variable, not guaranteed, paid after preferred |
| Priority in Liquidation | Higher claim than common stockholders | Last in line after all creditors and preferred stockholders |
| Capital Appreciation | Limited potential, price tied to interest rates | Higher potential for price growth |
| Risk Profile | Hybrid, less volatile than common, more than bonds | Higher volatility, higher potential reward |
The primary area of confusion often arises from both being forms of equity ownership. However, preferred stock prioritizes income and capital preservation during distress, while common stock emphasizes growth potential and corporate influence through voting rights.
FAQs
What does "preferred" mean in preferred stock?
The term "preferred" indicates that these shares have preferential rights over common stock. This typically means preferred stockholders receive their dividend payments before common stockholders, and they have a higher claim on the company's assets in the event of liquidation or bankruptcy.
Do preferred stockholders have voting rights?
In most cases, preferred stockholders do not have voting rights. This is a key difference from common stock, where shareholders typically vote on corporate matters such as electing the board of directors. Some preferred shares may have limited voting rights for specific extraordinary events, like a merger.
Is preferred stock considered debt or equity?
Preferred stock is considered a hybrid security, possessing characteristics of both debt and equity. It is classified as equity on a company's balance sheet, but its fixed dividend payments and priority in liquidation give it bond-like qualities, positioning it between traditional debt and common stock in the capital structure.
How does a callable preferred stock work?
A callable preferred stock includes a call option, which grants the issuer the right, but not the obligation, to repurchase the shares from investors at a predetermined price (often the par value) after a specific date. Companies typically exercise this option when interest rates fall, allowing them to reissue new preferred stock at a lower coupon rate and reduce their financing costs.
What is a cumulative preferred stock?
A cumulative dividend feature means that if a company misses any preferred dividend payments, those missed payments accumulate and must be paid to preferred stockholders before any dividends can be distributed to common stock holders. Non-cumulative preferred stock does not have this feature, so missed dividends are typically lost.