Stocks and Mutual Funds - Preferred Stock
Preferred stock is considered a senior equity, since preferred stockholders would be paid out prior to common stockholders in the event of liquidation. The term "preferred stock" refers to the fact its holders receive preferential treatment over common stockholders in the event of liquidation and when dividends are paid. Preferred stock actually has many characteristics of bonds, including:
- Fixed dividend rate - unlike common stock, whose dividend rate may rise or fall based on company profits, preferred stock is issued with a set rate based on the par value (usually $100, $50, or $25 per share).
- Interest-rate sensitive - due to the fixed dividend rate, the market price of preferred stock tends to increase when interest rates decline and decrease when they rise. And because there is no set maturity date, the price fluctuations are more dramatic.
- No voting rights - only common stock owners have voting rights in the corporation. Owners of bonds and preferred stocks do not.
- Callable - most preferred stocks can be called away after a set date. The corporation would tend to exercise this right if interest rates have fallen.
- Convertible - like some bonds, some preferred stocks are issued in convertible form. The conversion ratio is used to calculate the number of shares of common stock to be received upon conversion:
Conversion Ratio = Par Value of Convertible Bond
Conversion Price of equity
For example, an investor buys a convertible preferred stock at $100 par, which is convertible to the common at $25 a share. At that time, the market price of the common is $20 a share. The investor wouldn't choose to convert until the market price of the common equals or exceeds $25 a share (also called the parity price). To calculate how many shares of common stock would be received upon conversion, the investor would use the formula above: $100/$25 = 4. Therefore, the investor would receive four shares of common stock for each share of preferred stock converted. If the market price of the stock rose above the conversion price, the investor obtains the stock at a discount.
In the example above, if the stock's market price rose to $30 a share, the holder of convertible preferred stock could still acquire the common stock at a price of $25 a share.
Convertible preferred securities offer an answer for investors who want the profit potential of stocks but not the risk. Read more about these securities in the article Introduction to Convertible Preferred Shares.
Cumulative vs. Noncumulative Preferred Shares
Preferred stocks are issued as either cumulative or noncumulative. This refers to the payment of the dividend.
- It is possible that a corporation may not have the funds during some quarters to pay the expected dividend.
- When this occurs, noncumulative preferred stock holders have no rights to be paid the "skipped" dividends when dividends resume.
- However, cumulative preferred stock does pay these dividends when dividends resume; essentially, the missed dividends accumulate on the investor's behalf.
Exam Tips and Tricks
Consider this sample exam question on cumulative preferred stocks:
ABC Corporation has a cumulative preferred stock outstanding that pays a $4 dividend each year. Due to low sales, the dividend was not paid last year. Now that sales have improved, ABC is able to resume dividends this year. How much will the preferred stockholders receive this year?
The correct answer is "b", since it is a cumulative preferred stock. If it were a non-cumulative preferred, the correct answer would have been "a".
Common Stock Valuation Methods