What Is Preferred Stock?

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What Is Preferred Stock?

Let me explain preferred stock directly to you: it's a class of shares that gives you, the holder, a higher claim to dividends or asset distribution than those with common stock. There are two main types of shares in a company—common and preferred. As a preferred stockholder, you get priority on dividends or assets, but you usually receive no or fewer voting rights. The specifics depend on the particular issue of the stock.

Key Takeaways

Preferred stock is equity that means you own part of the company and have a right to its income. You, as a preferred stockholder, have a higher claim on things like dividends than common stockholders do. Typically, you get no or limited voting rights in how the company is run. If the company liquidates, you're paid before common stockholders but after bondholders. It mixes traits of bonds and common stock, which is why some investors find it appealing.

Understanding Preferred Stock

You should know that preferred shareholders like you get priority over common ones for dividends, which might come monthly or quarterly. These can be fixed or tied to something like the SOFR rate, often quoted as a percentage. Adjustable-rate shares have factors affecting the yield, and participating ones can give extra dividends based on common stock payouts or company profits. The board decides on dividends. Unlike common stockholders, your rights are limited, usually no voting. Preferred stock acts like debt with fixed dividends but like equity with appreciation potential, which suits you if you're after stable cash flows.

Types of Preferred Stock

Not every preferred stock is identical; they vary in features that make them more or less attractive. Prior preferred stock ranks highest for creditors or dividends—it's an earlier issue that gets paid first if funds are limited. Preference preferred stock comes next, with ranks like most senior or second senior among them. Perpetual preferred stock has no end date; you sell shares to get your money back, unlike some with a fixed return like bonds. Convertible preferred stock lets you trade for common shares anytime, but once done, you can't go back, and it's based on a set ratio. Cumulative preferred stock accumulates unpaid dividends that must be paid before any to lower tiers or common stock. Noncumulative means missed dividends don't carry over; it's common in banking due to regulations. Participating preferred stock can still get dividends tied to company performance, even in tough years, possibly on top of normal ones if finances allow.

Preferred Stock vs. Common Stock

Preferred and common stock both represent equity, but they differ significantly. You get a fixed dividend with preferred, paid before common ones, and even past years' if cumulative. Common stockholders might get nothing until preferred are satisfied. Preferred doesn't appreciate or depreciate as much as common, where value comes from potential growth. Preferred usually has no voting rights, while common does; preferred might convert to common, but not vice versa, and can be callable at par. In liquidations, preferred gets better treatment.

Comparison of Preferred and Common Stock

Both are equity ownership tradable on exchanges for public companies.
Preferred has first right to dividends before common.
Preferred typically lacks capital appreciation and voting rights but may convert to common and gets better liquidation treatment.
Common has no dividend guarantee, higher appreciation potential, voting rights, but worse in liquidations and no convert to preferred.

Preferred Stock vs. Bonds

Preferred stock resembles bonds with recurring payments, both issued at par value unrelated to market price, and dividends like coupon payments. But dividends aren't fixed—they can change or stop, often taxed lower than bond interest. Preferred has no maturity date usually, unlike bonds. In liquidation, bondholders come first, then preferred, then common. Missing a preferred dividend isn't default, so ratings are lower than bonds, yields higher.

Comparison of Preferred Stock and Bonds

Both offer periodic cash payments at par value independent of market.
Preferred dividends can vary or end; bonds have fixed interest and maturity.
Preferred is behind bonds in bankruptcy but has no end date.

Important Note on Cumulative Preferred Stock

Remember, cumulative preferred stock requires all past unpaid dividends to be paid before common shareholders get any—this contrasts with noncumulative, where missed payments don't accumulate.

Voting Rights, Calling, and Convertibility

Preferred shares generally don't give you voting rights, though sometimes they kick in if dividends aren't paid. They trade near issue price, like $25, with less appreciation than common. If callable, the company can buy them back at par after a date, say if rates fall. Convertible ones let you or the board exchange for common shares under set conditions, depending on common's market price.

Typical Buyers of Preferred Stock

You can buy preferred shares through brokers; they're varied and often combined in features, with no or distant maturity. Institutions buy most, especially initially, for tax advantages not available to you as a retail investor. They help raise capital easily. Issuers are often at credit extremes—some avoid more debt, others like big names use it for projects.

Advantages and Who Buys Preferred Stock

Preferred stock gives you higher dividends and asset claims in liquidation, plus callable features—it's like a hybrid with bonds. Investors seeking stable cash flow without high risk buy it, getting tax perks, though the company doesn't. Institutions and large firms are drawn for those tax benefits.

Example and Risks of Preferred Stock

Take a 7% preferred at $1,000 par: you get $70 yearly or $17.50 quarterly, trading near par like a bond, common in finance for capital. Yes, you can lose money; it's equity tied to company performance, so struggles mean price drops. Downside: less appreciation than common, no say in operations due to no voting.

The Bottom Line

If you're after cash flow from equities, preferred stock suits you—it prioritizes dividends but means owning part of the business with some trade-offs.

What Is Preferred Stock?