What is Preferred Stock?
Preferred stock, sometimes referred to as preference shares or preferred shares, is a kind of corporate ownership that combines features of both bonds and common stock (also known as ordinary shares).
Compared to ordinary stock, it is a class of stock that typically has a greater claim on the company’s assets and earnings.
Preferred stock has a higher priority in the distribution of assets and earnings than common stock, which is one of its main features.
Preferred investors have a stronger claim on the company’s assets in the case of liquidation or bankruptcy. As a result, preferred shareholders are more likely than common shareholders to receive their capital back in case of a firm liquidation.
Types of Preferred Stock
1. Cumulative preferred stock
This guarantees that if a company doesn’t pay dividends over a specific period, the unpaid dividends will accumulate and must be paid before any dividends will be granted to common shareholders.
2. Non-Cumulative preferred stock
Non-cumulative does not allow unpaid dividends to accumulate. Suppose a company fails to pay dividends during a given period. In that case, non-cumulative preferred shareholders do not have a claim to unpaid dividends in the future.
3. Convertible preferred stock
Convertible preferred stock allows shareholders to exchange their preferred shares for a set number of common shares. This feature allows preferred shareholders to profit from capital growth in the company’s common stock.
4. Participating preferred stock
Participating preferred shareholders are entitled to additional dividends and the predetermined dividend rate. This means they receive a share of any additional dividends paid to common shareholders.
5. Callable preferred stock
A company that issues callable preferred stock has the right to repurchase the shares at a specific price after a predetermined time. This gives the company the flexibility to buy back preferred shares from shareholders, typically when interest rates have dropped, or the company needs to restructure its capital.
6. Adjustable-rate preferred stock (ARPS)
This stock also known as floating-rate preferred stock, has a dividend rate that changes based on a predetermined benchmark or index. This ensures that the dividend payout reflects the current state of the market, including any changes in interest rates.
Advantages of Preferred Stock
- Fixed Income: Preferred shares frequently pay a fixed dividend, providing investors with a steady income stream.
- Tax Benefits: Dividends from preferred shares may be tax deductible, which helps lower the overall cost of ownership.
- Priority Payouts: In case of bankruptcy, preferred owners receive payment before common stockholders, ensuring their priority in receiving funds.
- Call Feature: Call feature grants the issuing corporation the ability to repurchase shares of preferred stock at a predetermined price. Suppose the market price of the stock surpasses the call price. In that case, this can present an advantage for investors, potentially resulting in higher returns.
- Conversion Feature: Some preferred stock issues include a conversion provision that enables shareholders to convert their preferred shares into common shares. Investors who anticipate better performance from the common shares in the future may find this feature advantageous, as it allows them to participate in potential gains.
Disadvantages of Preferred Stock
- Low Growth Potential: Preferred stock often does not increase in value as much as common stock,
- Higher risk of default: Default risk is common as it functions as a debt instrument. If the issuing firm fails to fulfil its obligations, preferred investors may not receive their expected dividends.
- Limited Voting Rights: Stockholders often lack voting rights, hence they do not influence how the corporation is governed.
Preferred stock has distinct characteristics that make it an attractive investment option. It provides a greater claim on assets and earnings, ensuring higher priority in case of liquidation. Different types such as cumulative, non-cumulative, convertible, participating, callable, and adjustable-rate also offer varying benefits.
However, understanding the advantages vis-à-vis its disadvantages can help investors better make informed decisions and diversify their investment portfolios.