What Is the Preferred Dividend Coverage Ratio?

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.

Key Takeaways

  • The preferred dividend coverage ratio indicates a company's ability to meet its obligation to pay dividends to preferred shareholders.
  • Common shareholders might use the ratio as an indicator of the likelihood that a company will choose to pay a dividend on common shares.
  • Because they pay a defined dividend, preferred shares are an income-producing investment similar to bonds.

Formula for the Preferred Dividend Coverage Ratio

The formula for the preferred dividend coverage ratio is:

PDPR = Net Income Required Preferred Dividend Payout where: PDPR = preferred dividend payout ratio \begin{aligned}&\text{PDPR}=\frac{\text{Net Income}}{\text{Required Preferred Dividend Payout}}\\&\textbf{where:}\\&\text{PDPR}=\text{preferred dividend payout ratio}\end{aligned} PDPR=Required Preferred Dividend PayoutNet Incomewhere:PDPR=preferred dividend payout ratio

Understanding the Preferred Dividend Coverage Ratio

This ratio is meant to give investors and analysts an idea of a company's ability to pay off its preferred dividend requirements. However, it also can give common shareholders an idea of how likely they are to be paid dividends.

Preferred dividends are paid out of net income before any money is allocated for common share dividends. If the company has a hard time covering its preferred dividend requirements, common shareholders are unlikely to receive a dividend payment on their own holdings.

The preferred dividend coverage ratio can be reduced if the company issues more shares of preferred stock or if the company's net income falls. Net income is computed by subtracting total expenses from total revenues and may decline if revenues fall or the costs of doing business increase.

Preferred dividends must be paid out of net income before any common share dividend is considered.

Preferred vs. Common Dividends

The boards 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.

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.

This gives preferred stock shares some similarity to bonds and other fixed-income investments. Preferred stocks are popular among investors seeking a steady income supplement. They are inclined to hold the stock for the long term.

There also are exchange-traded funds (ETFs) that focus on buying shares of preferred stocks.