Preferred stocks

Preferred Stocks

Preferred stocks are a type of equity security that represents ownership in a company, but possesses characteristics of both common stock and fixed income investments. Often considered a hybrid instrument within capital markets, preferred stocks typically offer a fixed dividend payment and hold a "preferred" status over common stock regarding dividend distributions and asset claims in the event of a company's liquidation. This blend of features makes preferred stocks distinct from other forms of ownership or debt.

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 preferred stocks were designed to attract investors by offering a higher dividend payout than common stock and a preferential claim on company assets in bankruptcy scenarios. Over time, as financial instruments evolved, preferred stocks became a more common tool for corporate finance, particularly for utilities and financial institutions seeking to raise capital while offering investors a balance between the stability of bonds and the potential for equity participation.

A significant moment in the regulatory history of preferred stocks occurred in 1979 when the U.S. Securities and Exchange Commission (SEC) issued Accounting Series Release (ASR) 268. This release modified the financial statement presentation requirements for redeemable preferred stocks, distinguishing them from traditional equity and requiring separate disclosure due to their debt-like characteristics and future cash obligations⁹.

Key Takeaways

• Fixed Dividends: Preferred stocks typically pay a fixed dividend that is usually higher and more consistent than common stock dividends.
• Dividend Priority: Holders of preferred stocks have priority over common shareholders in receiving dividend payments.
• Liquidation Preference: In the event of a company's bankruptcy or liquidation, preferred stockholders have a higher claim on the company's assets than common stockholders, but are subordinate to bondholders.
• No Voting Rights: Generally, preferred stockholders do not possess voting rights in corporate matters, unlike common stockholders.
• Hybrid Nature: Preferred stocks are considered a hybrid security, combining attributes of both equity and debt instruments, offering a unique position within a company's capital structure.

Formula and Calculation

The valuation of a perpetual preferred stock can be approximated using a simplified dividend discount model, similar to a perpetuity, given its fixed dividend payments. The formula to calculate the price of a preferred stock is:

Where:

• (P) = Price of the preferred stock
• (D) = Annual fixed dividend per share
• (r) = Required rate of return or discount rate (often reflecting prevailing interest rates and credit risk)

This formula assumes that the preferred stock pays a constant dividend indefinitely and has no maturity date, which is characteristic of many preferred issues.

Interpreting Preferred Stocks

Interpreting preferred stocks involves understanding their role as a hybrid security that sits between debt and common equity in a company's capital structure. For investors, preferred stocks are typically viewed as an income-generating investment, attractive for their steady dividend payments and preferential status. The fixed nature of their dividends means their prices are often sensitive to changes in interest rates, similar to bonds. A rising interest rate environment can decrease the present value of future fixed dividends, thereby lowering the preferred stock's market price⁸. Conversely, falling rates may make existing preferred stocks more attractive.

Hypothetical Example

Consider XYZ Corp. which issues a preferred stock with a par value of $100 and an annual dividend rate of 5%. This means the annual dividend payment per share is $5.

An investor, Sarah, is considering buying this preferred stock. If the market's required yield for similar preferred stocks is 4%, the theoretical price Sarah might be willing to pay for this preferred stock would be calculated as:

In this scenario, if the preferred stock is trading below $125, it might be considered undervalued relative to the market's required return. Conversely, if it trades above $125, it would be considered overvalued.

Practical Applications

Preferred stocks are utilized in various aspects of investing, market analysis, and corporate finance:

• Income Generation: For investors seeking a consistent income stream, preferred stocks can be a suitable option due to their fixed and preferential dividend payments. They often offer higher yields than many traditional fixed income instruments.
• Diversification: Due to their hybrid characteristics, preferred stocks can offer diversification benefits within a portfolio, as their correlation with common stocks and bonds can vary⁷.
• Corporate Financing: Companies, especially financial institutions and utilities, issue preferred stocks to raise capital without diluting the voting power of existing common shareholders or incurring the fixed interest obligations and default risk associated with traditional debt.
• Regulatory Capital: In some regulated industries, particularly banking, preferred stock can qualify as regulatory capital, making it an attractive financing tool. Regulators, such as the SEC, require specific disclosures for preferred stocks, especially those with mandatory redemption features, to provide transparency on their financial statement impact⁶.

Limitations and Criticisms

Despite their advantages, preferred stocks come with several limitations and criticisms:

• Limited Capital Appreciation: Unlike common stocks, preferred stocks generally offer limited potential for price appreciation. Their value is primarily tied to their fixed dividend payments and prevailing interest rates, not necessarily the underlying company's growth⁵.
• Interest Rate Sensitivity: Because preferred stock dividends are typically fixed, their market prices are inversely affected by changes in interest rates. A rise in interest rates can decrease the value of existing preferred stocks⁴.
• Call Risk: Many preferred stocks are callable, meaning the issuing company can repurchase them at a predetermined price after a certain date. If interest rates fall, companies may call option their preferred shares to reissue new ones at a lower dividend rate, forcing investors to reinvest at potentially less favorable yields³.
• Dividend Payment Risk: While preferred dividends have priority, they are not guaranteed. A company facing financial distress may suspend preferred dividend payments. Unlike bondholders, preferred stockholders have limited recourse if dividends are not paid, and these payments are not tax-deductible for the issuing firm, unlike interest on debt².
• Liquidity: The market for preferred stocks can be less liquid than for common stocks, potentially leading to wider bid-ask spreads and higher transaction costs¹.

Preferred Stocks vs. Common Stocks

Preferred stocks and common stocks both represent ownership stakes in a public company, but they differ significantly in their rights and characteristics. The primary distinction lies in dividend payments and voting rights. Preferred stockholders typically receive fixed dividends that are paid before any dividends are distributed to common shareholders. In the event of liquidation, preferred stockholders also have a superior claim to the company's assets compared to common stockholders. However, this preferential treatment usually comes at the cost of voting rights; preferred stockholders generally do not have a say in corporate governance or decision-making, whereas common stockholders typically have one vote per share owned. Furthermore, common stocks offer greater potential for capital appreciation, as their value can increase significantly with company growth, a feature usually limited for preferred stocks.

FAQs

Are preferred stocks considered debt or equity?

Preferred stocks are a hybrid security. While they represent ownership (equity), their fixed dividend payments and preferential claims in liquidation give them characteristics similar to bonds (debt). They are typically listed as equity on a company's balance sheet.

Do preferred stocks have voting rights?

In most cases, preferred stocks do not carry voting rights. This means preferred shareholders generally cannot vote on company decisions, board elections, or other corporate matters, unlike common stockholders.

What happens if a company misses a preferred dividend payment?

If a company misses a preferred dividend payment, it usually cannot pay dividends to common shareholders until all missed preferred dividends are paid. For "cumulative" preferred stocks, all missed dividends must be paid before any common dividends are resumed. For "non-cumulative" preferred stocks, missed dividends are generally lost forever.

Are preferred stocks safer than common stocks?

Preferred stocks generally carry less risk and return than common stocks due to their fixed dividends and higher priority in liquidation. However, they are not risk-free and are typically more sensitive to interest rate changes than common stocks and are subordinate to bonds.

Can preferred stocks be converted into common stock?

Some preferred stocks are "convertible preferred stocks," meaning they can be exchanged for a predetermined number of common shares. This feature can offer investors the potential to participate in the growth of the company if its common stock performs well, similar to convertible bonds.