Preferred Stock Dividend
A preferred stock dividend is a distribution of a company's earnings to its preferred stock holders, typically paid at a fixed rate and with priority over common stock dividends. This form of dividend payment falls under the broader category of corporate finance, representing a key aspect of a company's capital structure. Unlike common stock dividends, which fluctuate with a company's profitability and are not guaranteed, preferred stock dividends are usually predetermined and paid consistently, often quarterly or semi-annually. This predictability makes preferred stock an attractive option for investors seeking steady fixed income streams.
History and Origin
The concept of preferred stock emerged to attract investors seeking a more secure stake in a company's financial performance than traditional common shares. The very first preferred stock in the United States was reportedly issued by the Pennsylvania Railroad Company in the mid-19th century. These early preferred shares were designed to offer investors a higher dividend payout and a preferential claim on company assets in the event of financial distress. Over time, particularly in the early 20th century, preferred stock became a more widely adopted instrument, especially by large utilities and transportation companies, as a means of raising capital while offering investors a blend of equity ownership and bond-like income predictability.
Key Takeaways
- A preferred stock dividend is a payment made to preferred shareholders that takes priority over dividends paid to common shareholders.
- These dividends are typically fixed, often as a percentage of the stock's par value.
- In the event of a company's liquidation, preferred shareholders have a liquidation preference, meaning they are paid before common shareholders, though after bondholders.
- Many preferred stocks are cumulative, meaning any missed preferred stock dividends must be paid out before common shareholders can receive any dividends.
- Preferred stock generally does not carry voting rights, distinguishing it from common stock.
Formula and Calculation
The calculation of a preferred stock dividend is relatively straightforward, as the dividend rate is usually fixed at the time of issuance.
The annual preferred stock dividend per share can be calculated using the following formula:
Where:
- Par Value Per Share refers to the nominal or face value of the preferred stock, often set at a standard amount like $25 or $100.
- Dividend Rate is the stated percentage of the par value that will be paid as a dividend annually.
For example, if a preferred stock has a par value of $100 and a dividend rate of 5%, the annual preferred stock dividend per share would be ( $100 \times 0.05 = $5 ).
Interpreting the Preferred Stock Dividend
Interpreting a preferred stock dividend involves understanding its implications for both the investor and the issuing company. For an investor, the preferred stock dividend represents a predictable stream of income investing. The consistency of these payments, often quarterly, provides a clear expectation of returns, which is particularly appealing to those seeking stable cash flow, such as retirees or institutional investors.
From the company's perspective, the decision to issue preferred stock and pay preferred stock dividends is a strategic choice in its capital structure. While these dividends offer a way to raise equity without diluting voting control (as preferred stock typically carries no voting rights), they also represent a fixed financial obligation that must be met before any distributions to common shareholders. The dividend's fixed nature allows for easier forecasting of payouts compared to the variable nature of common stock dividends.
Hypothetical Example
Consider XYZ Corp., which issues 100,000 shares of preferred stock with a par value of $50 per share and an annual dividend rate of 6%.
-
Calculate the annual preferred stock dividend per share:
Annual Dividend Per Share = Par Value × Dividend Rate
Annual Dividend Per Share = $50 × 0.06 = $3.00 -
Determine the total annual preferred stock dividend obligation:
Total Annual Dividend = Annual Dividend Per Share × Number of Preferred Shares
Total Annual Dividend = $3.00 × 100,000 = $300,000
This means XYZ Corp. is obligated to pay $300,000 in preferred stock dividends annually. If XYZ Corp. has cumulative preferred stock, and they fail to pay this dividend in a given year due to financial difficulties, the $300,000 becomes a dividend arrearage that must be paid in future periods before any common stock dividends can be distributed. If the preferred stock is non-cumulative preferred stock, then the missed dividend payment is simply lost.
Practical Applications
Preferred stock dividends are most commonly observed in sectors requiring significant and stable capital, such as financial institutions, utilities, and certain industrial companies. These dividends serve as a regular income stream for investors and are a core feature for the issuing companies.
- Financial Institutions: Banks and insurance companies frequently issue preferred stock as a means of raising regulatory capital, and the associated preferred stock dividends provide a predictable return to investors, often institutional ones.
- Utilities: Utility companies, characterized by stable cash flows and high capital expenditures, find preferred stock to be an efficient way to finance infrastructure projects, offering attractive, steady preferred stock dividends to a broad base of shareholders.
- Retirement Portfolios: Individual investors, particularly those in retirement, often include preferred stock in their portfolios for the stable income provided by preferred stock dividends. This helps to generate consistent cash flow, similar to interest payments from bonds, making them suitable for income investing strategies.
It's important to note that while preferred stock offers stability, most large companies no longer offer preferred stock, with prominent exceptions being large banks.
Limitations and Criticisms
Despite the advantages of preferred stock dividends, there are several limitations and criticisms associated with them. One primary critique is the lack of capital appreciation potential compared to common stock. Since preferred stock dividends are typically fixed, preferred shareholders do not usually participate in the company's significant earnings growth beyond their stated dividend. This means the total return on preferred stock often comes predominantly from the dividend yield rather than stock price growth.
Another limitation is the absence of voting rights for most preferred shareholders. This means preferred shareholders have little to no say in corporate governance or strategic decisions, which are typically reserved for common stockholders. Furthermore, preferred stock, while less risky than common stock, is still subordinate to debt financing in a company's capital structure. In the event of bankruptcy, bondholders and other creditors are paid before preferred shareholders. The preferred stock asset class can also experience significant drawdowns during periods of financial instability, though typically with recovery.
Preferred Stock Dividend vs. Common Stock Dividend
The key distinctions between a preferred stock dividend and a common stock dividend lie in their priority, payment consistency, and associated shareholder rights.
| Feature | Preferred Stock Dividend | Common Stock Dividend |
|---|---|---|
| Priority | Paid before common stock dividends. | Paid after preferred stock dividends. |
| Consistency | Usually fixed and predictable, often guaranteed. | Variable, declared at the discretion of the board, not guaranteed. |
| Arrearage | For cumulative preferred, missed dividends accumulate and must be paid later. | Missed dividends are generally not owed in the future. |
| Voting Rights | Generally, no voting rights. | Typically includes voting rights. |
| Capital Gains Potential | Limited, as the stock price tends to be less volatile. | Higher, as the stock price can appreciate significantly with company growth. |
| Liquidation | Preferred shareholders have priority over common shareholders in receiving assets after creditors. | Common shareholders are last in line to receive assets during liquidation. |
The fundamental difference lies in the "preferred" status, which grants a higher claim on earnings and assets. Investors choose between these types of stocks based on their investment goals: income stability and lower risk with preferred stock, or growth potential and voting influence with common stock.
FAQs
Q: Are preferred stock dividends guaranteed?
A: While preferred stock dividends are generally fixed and have priority, they are not strictly guaranteed like interest payments on a bond. A company is only obligated to pay them if its board of directors declares a dividend. However, for cumulative preferred stock, any missed dividends accumulate and must be paid before any common stock dividends can be distributed.
Q: Do preferred stock dividends affect the company's debt?
A: No, preferred stock dividends are distributions of profit and do not affect a company's debt. Preferred stock is considered a form of equity and is part of the company's capital, not a liability in the same way as debt. However, the obligation to pay these dividends can influence a company's cash flow.
Q: Can preferred stock dividends be changed?
A: Typically, the dividend rate for preferred stock is fixed at the time of issuance and does not change. However, some types of preferred stock, like adjustable-rate preferred stock, may have dividends that vary based on a benchmark interest rate. The terms are clearly defined in the stock's prospectus.