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What is Preferred Stock?

What is Preferred Stock?

A stock represents ownership of a part of a company. Basically, there are two types of stock: common and preferred. Preferred stock has the characteristics of common stocks and bonds, which mean shareholders can rightfully benefit from a company’s profitability but can’t exercise their voting rights.

How Does Preferred Stock Work?

Preferred shareholders have a priority claim on a company’s assets. In the event of a bankruptcy, preferred stockholders receive compensation before common shareholders. Similarly, dividends allocated to a company’s preferred stocks have to be paid before dividends on common stocks are paid.

The dividends for preferred stocks are paid either quarterly or annually, which is a more regular payment schedule. These payments are based on a fixed rate, which is a given percentage of the preferred stock’s par value.

Preferred stocks offer more stability and are less risky than common stocks. However, gains on preferred stocks are limited because their prices change slowly, unlike common stocks where you have the potential for an unlimited upside.

Types of Preferred Stock

Generally, there are four preferred stock types: callable, convertible, cumulative, and participatory preferred stocks.

Learn more about each category of preferred stock below.

Callable

As its name suggests, an issuing company can decide to repurchase the shares at a fixed price. The company is likely to benefit more from such a step since it would prevent the corporation from paying out large sums of money in the future due to increasing interest rates. Companies also use callable preferred stocks as a way of financing their activities.

To redeem callable shares, a corporation forwards a notice containing the date and conditions of redemption to shareholders. Shares have to be returned on the set date in exchange for money.

Convertible

Convertible shares are shares that can be turned into common shares. As a preferred shareholder, you stand a chance to make a lot of money if the value of common shares moves up. However, you don’t receive any benefits until you exchange your shares. Also, note that once you convert a preferred share to a common share you can’t reverse that.

Cumulative

While a company is registering losses, there can be difficulty paying dividends to shareholders. Cumulative preferred shares protect shareholders when such misfortunes occur because a company must settle unpaid dividends to preferred stockholders before paying dividends to common stockholders.

For instance, if a company is required to pay dividends of $20 per share but doesn’t pay for two years, they must pay you the total amount from these two years in the third year (that amounts to $60) before paying any other dividends.

Participatory

Participatory preference shares offer extra profits to shareholders. Such gains are only guaranteed when a company attains certain revenue targets. You will receive your fixed dividends plus some additional income in such an event. The company determines the formula for calculating these extra earnings.

How Are Investors Affected?

Preferred stocks come with unique features that you’ll want to be aware of as an investor.

Voting Rights

Preferred stockholders have no voting rights. Therefore, they lack a voice in shaping the company’s direction. So, if a company has to vote on an issue, like electing directors, preferred shareholders can’t participate. However, in exceptional cases, the voting rights may revert to shareholders who haven’t been paid their dividends.

Perpetuity

Preferred stocks lack a defined term; therefore, as an investor, you continue receiving fixed dividends as long as the company is in operation unless they choose to call the shares.

Stable Prices

A company may sometimes make moves that would trigger an increase or a decrease in stock prices. For example, suppose a car manufacturer opens up new branches in foreign countries. It’s common for stocks to shoot up in anticipation of increasing production and supply and boost their earnings. On the other hand, there won’t be a significant increase in the preferred stocks’ price.

If the same car manufacturer shuts down some branches, the chances are high that the common-stock price will plunge massively, but the preferred-stock prices would likely not change much. As an investor, you may suffer little to no losses in this case.

Preferred Stocks vs. Common Stocks

The major difference between preferred and common shares is that preferred shareholders have no voting rights, whereas common stockholders can vote.

Secondly, preferred stockholders are given more priority than common stockholders during the payment of dividends.

Preferred Stocks vs. Bonds

Preferred stocks pay fixed dividends to investors, while bonds offer systematic interest payments. If a company collapses and is shut down, investors holding bonds are compensated before preferred stockholders. However, preferred stocks and bonds share a similarity in that both are affected by interest rates — when rates hike, they tumble, and when rates fall, they rise.

How to Purchase Preferred Stock

You can buy preferred stocks on exchanges where they are traded. However, many issuers don’t offer preferred stocks, and the ones that do are mainly insurance companies, banks, and real estate investment trusts.

Companies may offer more than one preferred stock option, so it’s up to you to weigh the benefits each has to offer and make a choice. You can find that an issuer has several preferreds, but their yields vary, and of course, anyone would want a stock that provides the highest yields.

The Bottom Line

Preferred stock and common stock are very different, although they represent an ownership stake in a corporation. Investors should have a deep understanding of these contrasts before putting their money into stocks.

Investors can reduce their investment risk through diversification, which entails investing in different preferred stocks.

If you are thinking long term — buying and holding — preferred shares should be your go-to investment. And although preferred shares have higher dividend security than common stocks, dividends are not always guaranteed.

RELATED CATEGORIES: Stock Market