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?

  1. $4
  2. $8
  3. $12
  4. $16

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
Related Articles
  1. Personal Finance

    RIAs and Brokers: What's the Difference?

    RIAs and brokers are held to different standards when providing investment advice. Here's how they differ.
  2. Investing Basics

    Brokers and RIAs: One and the Same?

    Brokers and registered investment advisors have some key differences. Here's what you need to know.
  3. Professionals

    Understanding Series 6

    Upon successful completion of the Series 6, an individual will have the qualifications needed to sell open end mutual funds and variable annuities
  4. Professionals

    Top Strategies on How to Become a Stock Broker

    Gunning to be a stock broker and want an edge? Here's some veteran advice.
  5. Trading Systems & Software

    Steps to Starting Up an Independent Broker Dealer

    Launching your own broker-dealer is a lot of work, but the potential payoff is great, both personally and financially.
  6. Professionals

    Understanding Series 63

    Series 63 is a securities license that entitles the holder to sell securities in a particular state.
  7. Professionals

    How To Answer Option Questions On The Series 7 Exam

    Learn how to answer option questions on the Series 7 exam. Pass your Series 7 exam with the help of these tips.
  8. Insurance

    Municipal Bond Tips For The Series 7 Exam

    Learn to distinguish between general obligation and revenue bonds to ace this test.
  9. Retirement

    6 Proven Tips For Series 6 Success

    These techniques can help you pass this test without the added stress.
  10. Insurance

    Tips For Passing The Series 6 Exam

    Find out what you can do during the test to make sure you get a passing score.
RELATED TERMS
  1. Series 6

    A securities license entitling the holder to register as a limited ...
  2. Series 79

    A examination to ensure a candidate is qualified to become a ...
  3. Research Analyst

    A person who prepares investigative reports on equity securities. ...
  4. Series 34

    An exam required for individuals seeking to engage in off-exchange ...
  5. Financial Advisor

    One who provides financial advice or guidance to customers for ...
  6. Series 23

    An exam offered by the Financial Industry Regulatory Authority ...
RELATED FAQS
  1. If I have only a limited amount of time to study for the Series 6, what should I ...

    The Series 6 Investment Company and Variable Contracts Products Representative Qualification Examination is administered ... Read Full Answer >>
  2. What role does the 'chip cycle' play in the electronics sector?

    There are several highly acclaimed private Series 6 Exam courses in the United States. Many can be completed online. Popular ... Read Full Answer >>
  3. What does passing the Series 6 enable me to do?

    The Series 6, or the Investment Company Products/Variable Contracts Limited Representative, exam is administered by the Financial ... Read Full Answer >>
  4. What are the differences between the Series 6 exam and the Series 7 exam?

    The Financial Industry Regulatory Authority (FINRA) offers a variety of licenses that must be obtained before conducting ... Read Full Answer >>
  5. Do I have to successfully complete the Series 7 exam before I can register for the ...

    There are no prerequisites to register for the Series 63 exam. However, once you have registered for the exam, you must schedule ... Read Full Answer >>
  6. I completed the Series 6, do I have to complete the entire Series 7?

    After having written the Series 6 examination, there would be significant overlap with the Series 7 in areas such as mutual ... Read Full Answer >>
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!