Complete Guide To Corporate Finance

AAA

Stock Valuation - Preferred Stock Features

Within the vast spectrum of financial instruments, preferred stocks (or preferreds) occupy a unique place. Because of their characteristics, they straddle the line between stocks and bonds. Technically, they are equity securities, but they share many characteristics with debt instruments. Some investment commentators refer to them as hybrid securities. In this article, we provide a thorough overview of preferred shares and compare them to some better-known investment vehicles.

Because so much of the commentary about preferreds compares them to bonds and other debt instruments, let's first look at the similarities and differences between preferreds and bonds.

Bonds and Preferreds: Similarities

Interest Rate Sensitivity
Preferreds are issued with a fixed par value and pay dividends based on a percentage of that par at a fixed rate. Just like bonds, which also make fixed payments, the market value of preferred shares is sensitive to changes in interest rates. If interest rates rise, the value of the preferred shares would need to fall to offer investors a better rate. If rates fall, the opposite would hold true. However, the relative move of preferred yields is usually less dramatic than that of bonds. (For further reading, check out Trying To Predict Interest Rates.)

Callability
Preferreds technically have an unlimited life because they have no fixed maturity date, but they may be called by the issuer after a certain date. The motivation for the redemption is generally the same as for bonds; a company calls securities that pay higher rates than what the market is currently offering. Also, as is the case with bonds, the redemption price may be at a premium to par to enhance the preferred's initial marketability. (To read more, see Call Features: Don't Get Caught Off Guard.)

Senior Securities
Like bonds, preferreds are senior to common stock; however, bonds have more seniority than preferreds. The seniority of preferreds applies to both the distribution of corporate earnings (as dividends) and the liquidation of proceeds in case of bankruptcy. With preferreds, the investor is standing closer to the front of the line for payment than common shareholders, although not by much.

Convertibility
As with convertible bonds, preferreds can often be converted into the common stock of the issuing company. This feature gives investors flexibility, allowing them to lock in the fixed return from the preferred dividends and, potentially, to participate in the capital appreciation of the common stock. (For further reading, see Introduction To Convertible Preferred Shares and Convertible Bonds: An Introduction.)

Ratings
Like bonds, preferred stocks are rated by the major credit rating companies, such as Standard & Poor's and Moody's. The rating for preferreds is generally one or two tiers below that of the same company's bonds because preferred dividends do not carry the same guarantees as interest payments from bonds and they are junior to all creditors. (For more insight, read What Is A Corporate Credit Rating?)

Bonds and Preferreds: Differences
Type of Security
As observed earlier, preferred stock is equity; bonds are debt. Most debt instruments, along with most creditors, are senior to any equity.

Payments
Preferreds pay dividends. These are fixed dividends, normally for the life of the stock, but they must be declared by the company's board of directors. As such, there is not the same array of guarantees that are afforded to bondholders. This is because bonds are issued with the protection of an indenture. With preferreds, if a company has a cash problem, the board of directors can decide to withhold preferred dividends; the trust indenture prevents companies from taking the same action on bonds. Another difference is that preferred dividends are paid from the company's after-tax profits, while bond interest is paid before taxes. This factor makes it more expensive for the issuing company to issue and pay dividends on preferred stocks. (To read more, see How And Why Do Companies Pay Dividends?)

Yields
Computing current yields on preferreds is similar to performing the same calculation on bonds: the annual dividend is divided by the price. For example, if a preferred stock is paying an annualized dividend of $1.75 and is currently trading in the market at $25, the current yield is: $1.75/$25 = 7%. In the market, however, yields on preferreds are typically higher than those of bonds from the same issuer, reflecting the higher risk the preferreds present for investors.

Volatility
While preferreds are interest rate sensitive, they are not as price sensitive to interest rate fluctuations as bonds. However, their prices do reflect the general market factors that affect their issuers to a greater degree than the same issuer's bonds.

Accessibility for the Average Investor
Information about a company's preferred shares is easier to access than information about the company's bonds, making preferreds, in a general sense, easier to trade (and perhaps more liquid). The low par values of the preferred shares also make investing easier because bonds, with par values around $1,000, often have minimum purchase amounts (i.e. five bonds).

Common and Preferred Stocks: Similarities



Payments
Both common and preferred stocks are equity instruments that pay dividends from the company's after-tax profits.

Common and Preferred Stocks: Differences



Payments
Preferreds have fixed dividends and, although they are never guaranteed, the issuer has a greater obligation to pay them. Common stock dividends, if they exist at all, are paid after the company's obligations to all preferred stockholders have been satisfied.

Appreciation
This is where preferreds lose their luster for many investors. If, for example, a pharmaceutical research company discovers an effective cure for the flu, its common stock will soar, while the preferreds in the same company might only increase by a few points. The lower volatility of preferred stocks may look attractive, but preferreds will not share in a company's success to the same degree as common stock. (To learn more, read 5 Signs Of A Market-Beating Stock.)

Voting
Whereas common stock is often called voting equity, preferred stocks usually have no voting rights.

Types of Preferred Stock
Although the possibilities are nearly endless, these are the basic types of preferred stocks:

  • Cumulative: Most preferred stock is cumulative, meaning that if the company withholds part (or all) of the expected dividends, these are considered dividends in arrears and must be paid before any other dividends. Preferred stock that doesn't carry the cumulative feature is called straight, or noncumulative, preferred.
  • Callable: The majority of preferred shares are redeemable, giving the issuer the right to redeem the stock at a date and price specified in the prospectus.
  • Convertible: The timing for conversion and the conversion price specific to the individual issue will be laid out in the preferred stock's prospectus.
  • Participating: Preferred stock has a fixed dividend rate. If the company issues participating preferreds, those stocks gain the potential to earn more than their stated rate. The exact formula for participation will be found in the prospectus. Most preferreds are non-participating.
  • Adjustable-Rate Preferred Stock (ARPS): These relatively recent additions to the spectrum pay dividends based on several factors stipulated by the company. Dividends for ARPSs are keyed to yields on U.S. government issues, providing the investor limited protection against adverse interest rate markets.

Why Preferreds?
A company may choose to issue preferreds for a couple of reasons:

  • Flexibility of payments: Preferred dividends may be suspended in case of corporate cash problems.
  • Easier to market: The majority of preferred stock is bought and held by institutions, which may make it easier to market at the initial public offering.

Institutions tend to invest in preferred stock because IRS rules allow U.S. corporations that pay corporate income taxes to exclude 70% of the dividend income they receive from their taxable income. This is known as the dividend received deduction, and it is the primary reason why investors in preferreds are primarily institutions.

The fact that individuals are not eligible for such favorable tax treatment should not automatically exclude preferreds from consideration. In many cases, the individual tax rate under the new rules is 15%. That compares favorably with paying taxes at the ordinary rate on interest received from corporate bonds. However, because the 15% rate is not an across-the-board fact, investors should seek competent tax advice before diving into preferreds.

Preferred Stock Pros

  • Higher fixed-income payments than bonds or common stock
  • Lower investment per share compared to bonds
  • Priority over common stocks for dividend payments and liquidation proceeds
  • Greater price stability than common stocks
  • Greater liquidity than corporate bonds of similar quality

Preferred Stock Cons


  • Callability
  • Lack of specific maturity date makes recovery of invested principal uncertain
  • Limited appreciation potential
  • Interest rate sensitivity
  • Lack of voting rights


An individual investor looking into preferred stocks should carefully examine both their advantages and drawbacks. There are a number of strong companies in stable industries that issue preferred stocks that pay dividends above investment-grade bonds. The starting point for research on a specific preferred is the stock's prospectus, which you can often find online. If you're looking for relatively safe returns, you shouldn't overlook the preferred stock market. (To learn more, see Is Your Portfolio Light On Stocks? It May Be Time For A Switch.)

Common Stock Valuation
Related Articles
  1. Term

    How Market Segments Work

    A market segment is a group of people who share similar qualities.
  2. Active Trading

    Market Efficiency Basics

    Market efficiency theory states that a stock’s price will fully reflect all available and relevant information at any given time.
  3. Professionals

    Is A Stockbroker Career For You?

    Becoming a stockbroker requires a broad skill set and the willingness to put in long hours. But the rewards can be enormous.
  4. Economics

    Understanding Cost-Volume Profit Analysis

    Business managers use cost-volume profit analysis to gauge the profitability of their company’s products or services.
  5. Fundamental Analysis

    5 Must-Have Metrics For Value Investors

    Focusing on certain fundamental metrics is the best way for value investors to cash in gains. Here are the most important metrics to know.
  6. Fundamental Analysis

    5 Basic Financial Ratios And What They Reveal

    Understanding financial ratios can help investors pick strong stocks and build wealth. Here are five to know.
  7. Investing

    What Investors Need to Know About Returns in 2016

    Last year wasn’t a great one for investors seeking solid returns, so here are three things we believe all investors need to know about returns in 2016.
  8. Investing Basics

    How to Analyze a Company's Inventory

    Discover how to analyze a company's inventory by understanding different types of inventory and doing a quantitative and qualitative assessment of inventory.
  9. Professionals

    A Day In The Life Of A Public Accountant

    Here's an inside look at the workdays of two experienced CPAs, to give you an idea of what it might be like to pursue a career as a public accountant.
  10. Professionals

    A Day in the Life of a Public Accountant

    There’s no typical day in the life of a public accountant, but one accountant’s experience may shed some light on what the career entails.
RELATED TERMS
  1. Tight Monetary Policy

    A course of action undertaken by the Federal Reserve to constrict ...
  2. Laissez Faire

    An economic theory from the 18th century that is strongly opposed ...
  3. Short-Term Debt

    An account shown in the current liabilities portion of a company's ...
  4. Audit

    An unbiased examination and evaluation of the financial statements ...
  5. Sortino Ratio

    A modification of the Sharpe ratio that differentiates harmful ...
  6. Climate Finance

    Climate finance is a finance channel by which developed economies ...
RELATED FAQS
  1. What should I study in school to prepare for a career in corporate finance?

    Depending on which area you want to specialize in, corporate finance can be one of the most competitive fields in business. ... Read Full Answer >>
  2. Why would a company issue preference shares instead of common shares?

    Preference shares, or preferred stock, act as a hybrid between common shares and bond issues. As with any produced good or ... Read Full Answer >>
  3. What is the difference between cost of debt capital and cost of equity?

    In corporate finance, capital – the money a business uses to fund operations – comes from two sources: debt and equity. While ... Read Full Answer >>
  4. What is the difference between gross profit, operating profit and net income?

    The terms profit and income are often used interchangeably in day-to-day life. In corporate finance, however, these terms ... Read Full Answer >>
  5. What is finance?

    "Finance" is a broad term that describes two related activities: the study of how money is managed and the actual process ... Read Full Answer >>
  6. What is the difference between positive and normative economics?

    Positive economics is objective and fact based, while normative economics is subjective and value based. Positive economic ... Read Full Answer >>
Hot Definitions
  1. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  2. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
  3. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
  4. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  5. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  6. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
Trading Center