What Is A Preferred Stock (Explained: All You Need To Know)

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What Is A Preferred Stock

Preferred stock refers to a type of equity securities that companies can issue to stockholders giving them certain rights and privileges to dividends or asset distribution.

In other words, a preferred stock allows its holder to have a higher claim on dividends and distributions as compared to common stockholders.

On the flip side, preferred stocks will not have any voting rights or may have very limited voting rights.

In essence, preferred stocks give up their voting rights in exchange for a higher claim to dividends or asset distribution.

In many ways, preferred stocks have common characteristics to bonds as the holder is entitled to receive dividends as per the terms of the issue.

However, unlike bonds, preferred stocks are equity securities.

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Preferred Stock Characteristics 

Although different preferred stocks can have slightly different terms of issue, in general, they have certain key characteristics.

The first important characteristic of preferred stocks is that they give their holders priority to receive dividends or distributions over common stockholders.

In many cases, the dividends on preferred shares are either set in fixed terms or can vary according to a designated benchmark.

However, the entitlement to receive dividends in priority comes at a price.

Preferreds stocks generally do not have any voting rights.

In other words, the preferred stockholders do not have a say in important company decisions.

They are given a higher claim to dividends and distributions but on the other hand, they have given up their voting rights.

Another important characteristic of preferred stock is that their price tends to vary in a similar way as bond prices vary.

Preferred stocks will have a tendency to change in price with changes in the market interest rates.

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Preferred Stock Payment Priority

A key feature of preferred stock is that it has the right to receive dividends in priority over common stockholders.

Whereas common stockholders are only entitled to dividends to the extent the company board declares dividends at its discretion, preferred stockholders are entitled to receive the dividends as per the terms of the issue.

In cases where the company suspends dividends due to financial difficulty, some preferred stocks will lose their right to dividends for the period of time the company did not pay dividends whereas other preferred stocks will be entitled to receive dividends in arrears.

The preferred stocks that are entitled to receive all the unpaid dividends in arrears are called “cumulative preferred stock”.

In situations when all of the company’s assets are sold and fully liquidated, preferred stocks are entitled to receive payment after all the debt holders are paid but in priority over common stockholders.

Another crucial feature of preferred stock is that if the company defaults on the dividend payments, preferred stockholders cannot put the company in default and exercise any claims against it.

Preferred stocks, just like common stocks, are equity securities that do not provide any guarantee or security as bonds or debt securities offer to creditors.

As a result, default on preferred shares exposes the company to less default risk than default on debt obligations.

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Types of Preferred Stocks

When companies issue preferred stocks, they can assign different rights and privileges to them.

As a result, there are different types of preferred stocks that you can issue.

Standard Preferred Stock:

The standard preferred stock is a type of preferred stock where the stockholder is entitled to receive dividends but does not have voting rights.

Many investors like to invest in this type of equity security as it provides a stream of dividend income over time and the stock price is less volatile than common stocks.

Callable Preferred Stock:

Another type of preferred stock is callable preferred stock.

If the preferred stocks are “callable”, it means that the company has the right to “call the back” or buy them back.

Companies may choose to buy back their preferred stocks for different reasons, particularly to save on having to make high dividend payments.

Convertible Preferred Stock:

Convertible preferred stocks can be exchanged into a certain number of common stocks in the company under certain conditions.

The conversion rights will be fully detailed in the terms of the issue.

In some cases, the holder has the option to convert the preferred stocks into common stocks whereas in other cases it may be done automatically.

Cumulative Preferred Stock:

Cumulative preferred stocks are a type of preferred stock where the company must pay the preferred stockholders any missed dividend payments before any payment can be done to other shareholders.

To the extent the company has the capacity to pay dividends, cumulative preferred stockholders will have to receive any dividends in arrears.

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Preferred Stock vs Common Stock

The main difference between preferred stocks and common stocks is that preferred stocks tend to pay dividends and are nonvoting whereas common stocks do not have guaranteed dividends and are voting stocks.

Both preferred stocks and common stocks are equity securities giving their holders ownership rights in the company.

However, the preferred stock value can go up to only a certain limit whereas common stocks have an unlimited potential upside.

Also, preferred stock prices tend to change slowly and are tied more closely to market interest rates whereas common stock prices tend to be more volatile and are affected by company performance and economic factors.

In addition, preferred stockholders are entitled to receive dividends before common stockholders receive dividends.

This means that if the company has the capacity to pay dividends, it must pay the dividends to preferred stockholders first and then use the remaining funds to pay dividends to common stockholders if it so chooses.

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Preferred Stock FAQ

What are the advantages of preferred stocks?

The main advantage of preferred stock is that it has the right to receive dividends and has a claim on the assets of the corporation in priority over common stockholders.

Preferred stocks are sort of a hybrid between common stocks and bonds.

They entitled their holders to dividends and have less price volatility but remain equity securities.

Why purchase preferred stocks?

Preferred shares are great for many investors looking to invest in more stable securities and earn passive income.

In many ways, preferred stocks behave in a similar way as bonds behave in the market.

Also, major credit rating agencies will rate preferred stocks.

Being aware of an issuer’s creditworthiness, investors can purchase preferred stocks by having a better understanding of the potential default risk to which they may be exposed.

Is preferred stock safer than common stock?

In general, preferred stocks are less risky than common stocks.

This is the case as preferred stockholders are entitled to receive dividends, have a higher claim on dividends than common stockholders, have a preference on company assets in case of liquidation, and are less volatile in price.

Also, preferred stocks are rated by major credit rating agencies just like debt instruments.

Takeaways 

So there you have it folks!

What does preferred stock mean?

In a nutshell, preferred stocks represent a component of a company’s share capital, provide its holders with certain rights to dividends and liquidation distribution, and have similarities with debt instruments.

The terms of the proffered stock are in the company’s articles of incorporation.

There are different types of preferred stocks giving their holders different rights, such as preferred rights to dividends, preference in assets, convertibility rights, callability rights, and higher dividend yields.

In exchange, preferred stocks are nonvoting shares.

There are many reasons why investors choose to purchase preferred stocks, such as higher dividends, priority access to assets, potential ability to convert the shares into common stocks, and lower price volatility.

Now that you know what are preferred stocks and how they work, good luck with your research!

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