Preferred Shares

A Preferred shares is a type of share capital that can have features a common stock doesn't have, such as properties of both an equity and a debt instrument. It is classified as a hybrid instrument.

Preference shares, known as "preferred," are a type of hybrid securities with equity and fixed income characteristics. It is a share of a company's stock with dividends paid out to its holders before issuing common stock dividends.

Preferred stocks come before common stock, but they come after bonds in terms of dividends payment and upon liquidation.

Most preferred shareholders don’t have a voting right at the company shareholder meetings. In other words, they don’t have a right to be a part of the board of directors election and M&A projects.

Like equity shares, preferred shares also indicate an ownership stake. They have no maturity date and are recorded under shareholder’s equity in a company's balance sheet.

There are a bunch of features of this kind of shares, including but not limited to:

• Preference for dividends.

• Preference in assets in the event of liquidation.

• Convertibility to common stock.

• Higher dividend yields.

The primary credit rating agencies rate preferred stocks lower than bonds because of two possible reasons:

• Preferred dividends do not carry the same assurances as bond interest payments.

• Preferred shareholders' claims are subordinate to those of all other creditors.

Preferred Share types

There are various types of preference shares; a few are explained below:

1. Cumulative preferred stock

Cumulative preferred stock is a type of equity that pays a fixed dividend on a predetermined schedule before the company's common stock dividend is distributed. The stock's par value typically determines the dividend amount.

If the dividend is not distributed for reasons such as net loss incurred, then the dividend amount will be accumulated to be paid on a later date.

The cumulative dividends rate is calculated by the following formula:

Dividends = dividends rate x par value

• If the dividends are paid quarterly, divide the dividends by four.

• If the dividends are paid semi-annually, divide the dividends by two.

Cumulative dividend = dividend x number of missed payments

Example:

Company XY has an 8% dividend on preferred shares with a par value of $200. Suppose XY often pays preferred shareholders dividends semi-annually. XY hasn't made dividend payments for the last two years; how much should they pay?

The number of payments = 2 payments x 2 years = 4 missed payments per two years.

Semi-annual dividends= (8%  x 200) / 2= $8 

Cumulative dividends= $8 x 4= $32

2. Noncumulative preferred stock

The noncumulative preferred stock enables the issuing business to cancel dividend payments which means shareholders don’t have a claim of missing dividends.

If a company in a particular year decides not to pay dividends, the shareholders of noncumulative preferred stock do not have a right to claim those payments in the future, even if the company later decides to pay dividends.

3. Participating preferred stock

Participating in preferred stock allows the shareholders to receive additional dividends if the company meets specific financial targets.

Regardless of the company's performance, investors who purchased these stocks receive their quarterly dividend plus an additional dividend if the company meets predefined sales, profits, or profitability targets.

Participating preferred shareholders may have the right to get back the purchase price of the stock if the company is liquidated.

4. Convertible preferred stock

These are preferred issues that can be traded for a set number of a company's common stock. This exchange can happen whenever the investor wants, no matter what the common stock price is on the market.

The goal is to mitigate the negative consequences of rampant shorting and dilutive operations on the OTC markets on investors.

Preferred shares advantages for companies and investors

The reasons for corporations issuing preferred stock differ from going public and offering common stock. Preferred stock is a type of equity financing that allows companies to raise funds without losing voting rights.

However, investors demand preferred stock, enabling them to get consistent dividends.

Preferred stock advantages for companies:

1. Preferred stocks provide a company with an alternative form of financing, such as pension-led funding.

2. Corporations use preferred shares to resist hostile takeovers by issuing preferred shares containing poison pills  (or forced exchange or conversion characteristics) that are activated following a change of control.

3. Preferred stock reduces the debt-to-equity ratio of the company. As a result, the company will be able to secure more funding from new investors in the future.

4. Preference shares are callable in most cases. To avoid interest rate risk and opportunity cost, a company, calls the shares at par value after a specific date.

5. It allow companies to limit the control they give shareholders regarding voting rights. Therefore, a firm can raise funds without losing control.

6. A corporation is not required to pay dividends if a company doesn't make enough profits in a given year.

7. Preference shares do not constitute a charge on the company's assets. The corporation can retain its fixed assets free in the future to raise financing.

8. Different types of preference shares may be issued depending on the market's demands.

9. Preference shares have a fixed dividend rate. In the case of rising earnings, a company can only give the equity shareholders the benefits of profits.

Preferred stock benefits for investors:

1. Portfolio diversification

Preferred stocks provide considerable benefits in the form of portfolio diversity when added to an investor's portfolio.

2. Higher dividends payment

Investors can get higher dividend payments as preference shares are more secure than bonds.

3. Greater security than common stockholders

Preferred stocks come before common stock in terms of dividends payments.

As a result, stockholders enjoy a better level of security than owners of common stock.

4. Predetermined dividend rate

A preferred share's dividends are determined at the time of issuance. Some preference shares have a cumulative provision, which means unpaid dividends must be paid before regular shareholders' payout.

As a result, a company makes a concentrated effort to ensure that dividend payments are made on time.

5. Lower volatility than equities

Preferred shares tend to trade around their par value under normal market conditions since they can be redeemed at that value by the issuer. However, preference shares fluctuate more than fixed income securities.

6. Tax-efficient yield

The dividends of preference shares aren’t taxed as interest income (securities). As a result, preference shares can provide a much better after-tax yield than fixed-income securities.

7. Premium from callable shares

The corporation can purchase back the shares since it is callable. You may receive more than you paid for the preferred stock if the callable price exceeds the par value.

8. Option of converting preferred stock to common stock

Preferred shareholders can convert their preferred shares to common stock. If the value of the common stock goes up a lot, they could sell their shares and use the money to invest in less risky investments.

Preferred Shares Risks:

Preferred stockholders have ownership in the company and enjoy many features, but it also has its own set of risks, including but not limited to:

1. Interest rate fluctuation (price)

Preferred stock dividends are usually fixed. Comparable to the secondary market price of bonds, the market price of preferred stocks tends to be interest-rate sensitive.

The market price of preferred stocks tends to go up when interest rates fall. When the interest rate increases, the market price of the preferred stock goes down.

2. No dividends guaranteed

Preferred stock dividends are typically paid before any dividends to common stockholders. However, there is no guarantee that dividends will be settled forever as the interest payments on the company’s bond.

Bondholders can file a lawsuit against the corporation if the company fails to make an interest payment on its bonds. Preferred shareholders cannot sue a corporation if it fails to pay dividends since the company is not regarded to be in default.

3. Call provision

A call provision is included in some preferred stocks, allowing the corporation to redeem its preferred shares.

When interest rates fall, a corporation is more likely to call its preferred stock. In this case, the corporation may reduce costs by redeeming the store for its par value and then reissuing it at the current reduced interest rate.

Investors could miss out on any possible capital gains from growing market prices, and they may have to reinvest the money at a lower interest rate.

4. Liquidation risk

Regarding liquidation, bondholders' claim on the company’s assets is greater than preferred stock. So, preferred bondholders get their money before preferred stockholders.

5. Rating risk

The same credit rating firms that rate bonds rate preferred stocks. Moody's, Standard & Poor's, and Fitch Ratings are the three main rating companies. While preferred stocks can be rated investment-grade, many are rated below BBB and are therefore called speculative.

Difference between common and preferred stock:

The significant distinction between preferred and common stock is that preferred stock functions more like a bond with a fixed dividend.

In contrast, common stock payouts are less guaranteed and represent a higher risk of loss if a firm fails.

Common stock:

1. Investor type: Common stock is suitable for long-growth investors.

2. Dividends: dividends on the common stock might fluctuate or even be eliminated, whereas preferred stock dividend yields are significantly greater than dividends on common stock and aren't fixed at a specific rate.

3. Availability of common stock: Investors who purchase Common stock receive a portion of ownership in the company. Many companies only issue common stock, and the volume of common stock traded on stock exchanges is far higher than preferred stock.

4. Voting rights: Common stockholders often have the right to vote on the firm's board of directors and be a crucial part of the decisions process made by the corporation, such as mergers and acquisitions.

5. Fluctuation of share price: Common stock prices are more likely to fluctuate than preference stocks.

The most appealing aspect of common stock is that it represents ownership in the company.

As a firm grows more significant and generates more profits, its share prices will increase dramatically.

Therefore, the investor will enjoy better returns. However, they can experience losses if the company shares price drops over a short period.

For example, if Netflix’s common stock prices continuously drop, then it will result in enormous losses for its shareholders.

Preferred stock:

1. Investor type: Preferred stock is suitable for high-yield dividends investors.

2. Dividends: Preferred stock dividend yields are significantly greater than dividends on common stock and are fixed at a specific rate. In contrast, dividends on the common stock might fluctuate or even be eliminated outright.

3. Availability of preferred shares: Investors who purchase preference shares receive more features similar to that of a bond. The volume of preferred stock traded on stock exchanges is lower than that of common stock.

4. Voting rights: Preferred stockholders don’t have the right to vote on the firm's board of directors and be a crucial part of the decision-making process. In other words, they don’t have a say in the company's new investment decisions, such as mergers and acquisitions.

5. Fluctuation of share price: Preferred stock prices are more stable, so investors shouldn’t worry about it. The most attractive feature of preferred stock is its lower share price fluctuation rate.

As a result, the value of a company rises in investors' eyes, such as retirees who prefer more stable and less risky investments.

The investors will benefit from its stable price and hence will not experience unexpected losses associated with decreasing market share prices.

In other words, preference stockholders' chances of losses significantly drop as the company's stock price rarely falls dramatically in a short period.

Researched and authored by Khadega Bazarah | LinkedIn

Reviewed and edited by Sakshi Uradi | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Common Stock
• Cost of Equity
• Equity Capital Market (ECM)
• Outstanding Shares
• Participating Preferred Stock