Prior to buying stocks, investors must understand the whole process of stock trading, be aware of different types of stocks and their features, as well as remember about associated pros and cons. Why are some stocks referred to as “preferred”? What is a preferred stock? What can it offer investors, and how safe is it to purchase such shares? This is a detailed and explanatory guide on preferred stock and all information needed before making preferred stock investment decisions. Let us take a ride.
Preferred Stock Defined
Preferred stock is one of the top two types of stock that publicly traded companies issue to investors and represents a type of ownership in a company that an investor receives in exchange for buying the shares of the company. It accords shareholders ownership rights, including specified dividends. However, unlike common stock, which gives investors a vote for each share, preferred stock has no voting rights.
Understanding Preferred Stock
Almost anyone can buy the shares of a company as long as it is publicly traded. Offering preferred shares, companies raise capital in the primary or secondary market to settle debt, develop, invest in growth, and more.
There are a few characteristics that differentiate preferred stock from other types and make them unique:
- No voting rights. A major feature of preferred stock is its lack of voting rights. Although being a holder of a preferred stock in a company means partial ownership, this does not grant the privilege to participate in internal elections or participate in some decision-making.
- Higher dividends. Preferred stockholders enjoy higher dividends. Usually, companies distribute more of their assets and earnings to this set of investors as compensation for their financial commitment.
- Greater claim. As preferred stock offers higher dividends, its holders are also accorded preference compared to their counterparts. People who buy preferred stock have a greater claim to a company’s assets and earnings. This means that they are prioritized over common stockholders. As such, they are the first to receive arrears in case a company misses a dividend payment. Preferred stockholders also have higher claims to a company’s assets in the event of liquidation.
- Callability. Preferred shares have a callability characteristic that may cause the issue of redeeming the shares. This works when the stock issuer calls back the shares bought by investors at a redemption rate. Typically, the stockholders look forward to callbacks as the prices may be bid up.
- Convertibility. Holders of preferred stock may convert their shares into common shares.
- Fixed return. Preferred stock is a type of equity security that guarantees fixed return rates to its holders. Investors can rest assured that the return will come in as when due, except in special cases. And if the company defaults, preferred stockholders are considered first during arrears payment.
Types of Preferred Shares
Investors considering preferred shares also have to decide on the type of preferred shares to opt for. The types of preferred shares differ in features and the available benefits to holders.
- Prior preferred shares. Owners of prior preferred shares are of prime concern to companies during dividend payments. As a matter of fact, all preferred shareholders are a priority to the company. However, an establishment is obligated to attend to prior preferred shareholders in a case where it can only afford to pay dividends to a category of investors. Although it offers a lower yield, prior preferred shares have less credit risk than other preferred stocks.
- Preference preferred stock. Following prior preferred shares in terms of prioritization is the preference preferred stock. This type of preferred shares is superior to other variants apart from the prior preferred. In cases where a company issues more than a tier of preference preferred shares, each issuance is referred to by its ranking such as first preference, second preference, third preference and it goes on.
- Cumulative preferred stock. Sometimes, companies use dividends to investors but do not actually pay them out. In this case, the unpaid compensation piles up over time to become cumulative preferred stock. The good news is cumulative preferred stock will be paid in the future, and holders take precedence over common stock during payment. Hence, investors in this category will receive their payment before others in the lower tier.
- Noncumulative preferred stock. This is the direct opposite of cumulative preferred stock. While missed dividends accumulate for cumulative preferred stocks, unpaid ones do not pile up for noncumulative preferred stock. Dividends are treated year-to-year, and prior outstanding will not roll over.
- Convertible preferred stock. Shareholders can convert their convertible preferred stock into the company’s shares. Usually, the company would have set guidelines on the number of common shares the convertible preferred stock can be exchanged for. Also, the conversion can happen at any time, based on the investors’ readiness. However, once a convertible preferred stock is exchanged for common shares, the action cannot be reversed. This simply means investors can change convertible preferred stock to common shares, but the common shares cannot be changed back into convertible preferred shares.
- Perpetual preferred stock. Perpetual preferred stock has no fixed date that investors will receive their capital. While the initial capital invested will not be returned to the investors, they have access to redemption privileges.
- Participating preferred stock. Even when a company is unable to pay dividends to some investors, participating preferred stockholders are still entitled to a dividend. The payment often results from the company achieving predetermined sales, earnings, or profits and comes as an additional dividend. This is not the same as the usual dividend that goes out to all shareholders.
- Exchangeable preferred stock. It is possible to exchange this type of stock for some other security.
Preferred Stock on Balance Sheet
The cost of preferred stock is calculated by dividing the annual preferred dividend payment by the stock’s market value per share.
Cost of Preferred Stock = (Preferred Stock Dividend Per Share (DPS) / Current Price of Preferred Stock)
Preferred Stocks vs Common Stocks vs. Bonds
While preferred stocks offer fixed dividends to holders, including priority payment over common stockholders, who also have ownership, bonds do not. Instead of ownership rights, bonds represent a loan from an investor to the bond issuer. Typically, the common issuers of bonds are companies or governments to generate funds.
Preferred stocks and bonds have some similarities to common stocks. Firstly, the two types have a fixed income value. Holders of either the preferred stocks or bonds are aware of the amount eligible to them per the amount of their investment, and this value is fixed with no flexibility. However, the dividend companies pay common stockholders varies, depending on the business’s financial performance.
More similarities between preferred stocks and bonds that distinguish them from common stocks are the callability features. They have a par value and can be fixed with a maturity date, usually lasting 30 years or more.
Why Invest in Preferred Stocks?
There are many advantages to investing in preferred stocks. Firstly, all investors want peace and assurance as their money is at stake, and preferred stocks offer some kind of assurance with their fixed return. Whether the company records losses or profits, preferred shareholders will receive their dividends as at when due, except on special occasions.
Secondly, preferred stocks come with priority. Although the return is fixed, the company may default in payment to pay later. In this case, preferred stockholders are prioritized and paid before common shareholders. As a matter of fact, if the company does not have enough money to pay all its investors, preferred stock owners are still considered first. The priority given to preferred stock is also effective in case of a company liquidation. These categories of investors are given precedence for payout.
Thirdly, preferred stocks’ callability leaves room for the possibility of the call price being higher than the initial price the investor paid to own the shares.
Further, there is less chance of fluctuation for preferred stocks.
Notably, it would be incomplete to talk about the benefits preferred stock offers, without mentioning its downside. Some of the cons of preferred stocks are the absence of voting rights, low growth potential, and low to moderate liquidity possibility.
How to Invest in Preferred Stocks
Investing in preferred stocks requires going through a broker or brokerage firm. It is essential to research before taking this risky step and be convinced that preferred stocks are a choice. Many broker firms operate online and allow new signups with low minimum balances. However, workers differ according to the services they offer. Some charge high commissions that may not be the best for new investors.
It is often advisable to start with a few shares and keep an eagle eye on them before purchasing more. The specific processes of executing a trade depend on the platform.
To sum up, all investments are risks. Investment is not compulsory. Interested persons should decide to buy stocks of their own will, with full knowledge of the associated pros and cons. Preferred stocks are a good choice if you want to have a stable fixed income.