What Is a Preferred Dividend?
A preferred dividend is a dividend that is allocated to and paid on a company's preferred shares. If a company is unable to pay all dividends, claims to preferred dividends take precedence over claims to dividends that are paid on common shares.
- Preferred dividends refer to the cash dividends that a company pays out to its preferred shareholders.
- One benefit of preferred stock is that it typically pays higher dividend rates than common stock of the same company.
- A company declares all of its future preferred dividend obligations in advance, and so must allocate funds for that purpose where they accumulate in arrears.
- Preferred dividends must be paid out of net income before any common share dividend is considered.
Understanding Preferred Dividends
The boards of directors of public companies determine whether to pay a dividend to holders of its common stock and how much to payout. The dividend is a reward to stockholders. It represents their share of the company's profits and is an incentive for them to hold onto the stock for the long term. The board may raise, reduce, or eliminate its dividend based on the recent success of the business and depending on what other priorities it sees for the money.
Preferred dividends are issued based on the par value and dividend rate of the preferred stock. While preferred dividends are issued at a fixed rate based on their par value, this may be unfavorable in high inflation periods. This is because the fixed payment is based on a real rate of interest and is typically unadjusted for inflation.
The dividends for preferred stocks are by definition determined in advance and paid out before any dividend for the company's common stock is determined. The dividend may be a set percentage or may be tied to a particular benchmark interest rate. The dividend is generally paid on a quarterly or annual basis.
How to Calculate Preferred Dividend
All issuances of preferred stock contain the equity’s dividend rate and par value in the preferred stock prospectus. The dividend rate multiplied by the par value equates to the total annual preferred dividend. If the total dividend to be received is paid out in installments, such as in quarters, the issuer divides the total preferred dividend by the number of periods to get an approximate installment payment.
The preferred dividend coverage ratio is a measure of a company's ability to pay the required amount that will be due to the owners of its preferred stock shares. Preferred stock shares come with a dividend that is set in advance and cannot be changed. A healthy company will have a high preferred dividend coverage ratio, indicating that it will have little difficulty in paying the preferred dividends it owes.
Dividends in Arrears
A business may elect to forgo payment of dividends. Because preferred stockholders have priority over common stockholders in regards to dividends, these forgone dividends accumulate and must eventually be paid to preferred shareholders. Therefore, preferred stock dividends in arrears are legal obligations to be paid to preferred shareholders before any common stock shareholder receives any dividend. All previously omitted dividends must be paid before any current year dividends may be paid.
Preferred dividends accumulate and must be reported in a company’s financial statement. Noncumulative preferred stock does not have this feature, and all preferred dividends in arrears may be disregarded.
Other Preferred Dividend Features
Preferred stockholders typically receive the right to preferential treatment regarding dividends, in exchange for the right to share in earnings in excess of issued dividend amounts. Some preferred stockholders may receive the right of participation, in which their dividends are not restricted to the fixed rate of interest. However, a majority of preferred stock issuances are nonparticipating.
Callable preferred stock results in higher preferred dividends, as investors are sacrificing long-term security. If the preferred stock is retired at the call price, future preferred dividends may be included in the repurchase. Convertible preferred stock has lower preferred dividends, as the investor receives the additional of converting the preferred stock to common stock.