Equities - Preferred Stock
Remember, common stock is just one form of ownership. Another popular type of ownership is preferred stock, which is very similar to bonds in that it provides steady income.
Benefits of Preferred Stocks
Shares of preferred stock are typically non-voting, but they pay a steady dividend. They have other benefits too:
- If a company is to be liquidated, preferred stockholders have priority over common stockholders.
- If a company does not have enough earnings in a period to pay dividends to both the preferred and the common stockholders, those with preferred stock will be the ones paid.
A company can issue more than one class of preferred stock, with different classes taking precedence over others in terms of distribution of assets or dividends.
Memorize the differences between the five different types of preferred shares.
Types of Preferred Stock
There are generally five different types of preferred stock:
- Cumulative preferred stock has a provision that ensures it pays a steady dividend at regular intervals. If a company cannot pay a dividend, it keeps a record of all the dividends that should have been paid on the cumulative preferred stock. These accumulated dividends must be paid before any payment is made to the common shareholders. Preferred stock is designated as either cumulative or non-cumulative, meaning that the articles of incorporation do not formally stipulate this arrangement.
- Participating preferred stock allows the holder to receive additional dividend distributions under specified conditions. The condition is, typically, if the dividend on the common stock rises above a defined threshold. Thus, participating preferred stock provides all the upside potential of common stock with all the steadiness of preferred. Companies that urgently need an infusion of money - early-stage start-ups looking for venture capital - might float participating preferred issues. Most preferred stock, however, is non-participating.
- Convertible preferred stock gives the holder the option to exchange it for shares of the issuer's common stock according to a defined ratio. Like participating preferred stock, it tries to give select investors the benefits of both stock and bond holding.
These securities offer an answer for investors who want the profit potential of stocks but not the risk. Read more within the article Introduction to Convertible Preferred Shares.
- Callable preferred stock can, at the issuing company's choosing, be repurchased and added to the treasury stock. The investor would have no choice or recourse but to return it for the agreed-upon call price. Then again, it is usually no secret when a company wants to do this, as callable preferred shares are always covered by a sinking fund provision. A sinking fund is money that is taken from a corporation's earnings and used to redeem preferred shares or corporate bonds periodically. If a preferred stock issue has a sinking-fund provision, it means a portion of the issue must be retired each year.
- Adjustable-rate preferred stock dividends vary with some benchmark, typically the T-bill rate. Because adjustable-rate preferred stock always provides returns consistent with prevailing interest rates, its share price does not tend to move much.