Preferred stock is a type of equity security that represents ownership in a company and has characteristics of both stocks and bonds, making it a hybrid security. As a component of a company's capital structure within the broader category of securities, preferred stock typically pays its holders a fixed dividend before common stockholders receive any payments. This fixed payout often resembles the regular interest payments of a fixed income instrument like a bond.
History and Origin
The concept of preferred stock emerged to offer investors a middle ground between the stability of debt instruments and the growth potential of equity. Early forms of preferred stock can be traced back to the 19th century, evolving as a way for corporations to raise capital without diluting common shareholder control or taking on additional debt that would incur immediate interest obligations. A notable period of its expansion was during the Great Depression in the United States. During this time, the Reconstruction Finance Corporation (RFC) was granted authority in March 1933 to recapitalize banks through purchases of preferred stock, providing a crucial mechanism for financial institutions to strengthen their balance sheets.9 This government involvement helped popularize preferred stock as a viable financial instrument for corporate financing.
Key Takeaways
- Preferred stock typically pays fixed dividends, which must be paid before any dividends to common stockholders.
- In the event of a company's liquidation, preferred stockholders have a higher claim on assets than common stockholders but are subordinate to bondholders.
- Unlike common stock, preferred stock usually does not carry voting rights.
- Many preferred stocks are callable (can be repurchased by the issuer) or convertible into common shares.
- Preferred stock often offers a higher yield compared to common stock or comparable corporate bonds, attracting income-focused investors.
Formula and Calculation
The dividend yield for a preferred stock can be calculated using a straightforward formula. This calculation helps investors understand the annual income generated by the preferred stock relative to its current market price.
Annual Dividend Yield = (\frac{\text{Annual Dividend Per Share}}{\text{Current Market Price Per Share}})
Where:
- Annual Dividend Per Share refers to the total fixed dividend amount paid out per preferred share over a year.
- Current Market Price Per Share is the price at which one preferred share can be bought or sold in the market at a given time.
This formula is crucial for evaluating the investment's income potential and comparing it with other financial instruments.
Interpreting the Preferred Stock
Interpreting preferred stock involves understanding its unique position in a company's capital structure and its distinct features. Because preferred stock combines elements of both equity and debt, its valuation and appeal can fluctuate with changes in interest rates and the issuer's financial health. A higher dividend yield might suggest greater perceived risk or a depressed market price, while a lower yield could indicate stability or strong demand. Investors often analyze the company's ability to consistently pay the preferred dividend, as well as its overall financial leverage and industry outlook, to assess the security's quality.
Hypothetical Example
Imagine "InnovateCorp" issues 100,000 shares of preferred stock with a par value of $100 and an annual fixed dividend rate of 5%. This means each preferred share pays a fixed annual dividend of $5 ($100 par value * 0.05).
An investor, Sarah, purchases 100 shares of InnovateCorp's preferred stock at its par value of $100 per share.
- Total investment: 100 shares * $100/share = $10,000.
- Annual dividend income: 100 shares * $5/share = $500.
If the market price of InnovateCorp's preferred stock later rises to $110 per share, the dividend yield for new investors would decrease, even though Sarah's dividend payment remains fixed. Conversely, if the price drops to $90, the yield would increase for new investors. This example highlights the predictable income stream for existing shareholders, while also showing how market price changes affect the effective yield for new buyers.
Practical Applications
Preferred stock is primarily used by companies to raise capital without issuing additional debt or diluting common equity ownership. For investors, preferred stock can be an attractive option for income generation, often providing a higher and more stable dividend stream than common stocks. Financial institutions, in particular, frequently issue preferred shares to meet regulatory capital requirements, as these instruments can often qualify as Tier 1 capital.8 For instance, Bank of America has historically issued various series of preferred stock, demonstrating its use in corporate finance and capital management.7,6 Such issuances allow companies like Bank of America to strengthen their capital base and fund operations.5 Additionally, the tax treatment of preferred stock dividends can be advantageous for some investors, as many preferred dividends may qualify for a lower tax rate, similar to capital gains, rather than being taxed as ordinary income, as explained in IRS publications.4,3
Limitations and Criticisms
Despite their benefits, preferred stocks have limitations and criticisms. One significant drawback is their limited upside potential; unlike common stocks, preferred shares typically do not participate in the company's growth beyond their fixed dividend payments. This means that if the company performs exceptionally well, preferred shareholders do not see an increase in their dividend payments or a substantial rise in share value due beyond par value. Another criticism is that while preferred stock has a higher claim on assets than common equity during liquidation, they are still subordinate to all forms of debt. This makes them riskier than bonds in the event of bankruptcy.2 Some preferred shares are also callable, allowing the issuing company to repurchase them, often at par value, which can happen when interest rates fall, forcing investors to reinvest at lower yields. The Financial Times has highlighted "the hidden dangers of preferred shares," emphasizing that their fixed income-like characteristics can lull investors into a false sense of security regarding risk.1 Furthermore, preferred stock typically lacks voting rights, giving holders no say in corporate governance or management decisions.
Preferred stock vs. Common stock
The primary distinctions between preferred stock and common stock lie in their claim on company assets, dividend payments, and voting rights.
| Feature | Preferred Stock | Common Stock |
|---|---|---|
| Dividends | Fixed, typically higher, and paid first | Variable, generally lower, and paid after preferred |
| Claim on Assets | Higher priority than common stock in liquidation | Lowest priority in liquidation |
| Voting Rights | Generally none | Carries voting rights for corporate governance |
| Appreciation | Limited, primarily through fixed payments | Unlimited, participates in company growth |
Preferred stock offers a more predictable income stream and a higher claim in bankruptcy compared to common stock, appealing to income-focused investors. Conversely, common stock provides the potential for greater capital appreciation and voting power, making it attractive to growth-oriented investors seeking influence in corporate decisions. Understanding these differences is crucial for investors weighing equity investment choices.
FAQs
Are preferred stock dividends guaranteed?
Preferred stock dividends are typically fixed and stated as a percentage of par value, but they are generally not guaranteed in the same way bond interest payments are. While companies prioritize preferred dividends over common dividends, they can defer or omit payments if facing financial difficulties. However, many preferred stocks are cumulative, meaning any missed dividends must be paid to holders before common stockholders can receive any payments.
How does preferred stock behave in a rising interest rate environment?
In a rising interest rate environment, the value of existing preferred stock with fixed dividends typically declines. This is because their fixed dividend payments become less attractive compared to new securities issued with higher yields. Investors may sell existing lower-yielding preferred stock to buy newer, higher-yielding ones, driving down the prices of older issues.
Can preferred stock be converted into common stock?
Yes, some preferred stocks are convertible. This feature allows holders to convert their preferred shares into a specified number of common shares at certain times or under certain conditions. This can provide an opportunity for preferred stockholders to participate in the company's growth if its common stock performs well.
Is preferred stock considered debt or equity?
Preferred stock is considered a hybrid security because it possesses characteristics of both debt and equity. Like debt, it often pays a fixed income stream and has a par value. Like equity, it represents ownership in a company and its payments are dividends, not interest, and it is subordinate to debt in liquidation.