Understanding Preferred Stock: What You Need to Know

What is Preferred Stock?

Preferred Stock is a form of financing combining the hybrid feature of debts and common stocks. It is a kind of stock that usually makes sure the fixed rate of dividend is at the discretion of the board of directors with no voting to the preferred stockholders in the company meetings. 

In this article, we will discuss the ins and outs of preferred stock, including its features, advantages, and potential drawbacks.

Features of Preferred Stock

Ⅰ) Preferred Stock Has Cumulative Dividend Feature:

Almost, all preference shares have this feature. It is a cumulative dividend feature that all unpaid dividends will be accumulated and paid before any dividend payments to common stockholders. The preferred stock dividend is omitted due to a lack of the corporation's income, in case of restoration of revenue. So, a corporation must pay dividends on arrears on its preferred share.

Ⅱ) Preferred stockholders may Have Voting Rights in Special Situations:

Normally, due to prior claim assets and revenue, preferred stockholders have no participation in the management decision. There can be an agreement between the company and preference shareholders to give voting power in case of special situations, the company is facing financial difficulty and no dividend will be paid to common stockholders unless the specific financial ratios are not fulfilled.

Ⅲ)Certain Preferred Stocks Have Conversion into Common Shares:

Certain preference shares have a conversion option to common stock. Basically, all convertible securities have a call option and an issuing company can put the call to buy at a Call Price.

This call option is exercised, if the market price is significantly above the Call Price. So, upon conversion, a preferred stock is retired.

The Maximum Return to the Preferred Stock Holder

The maximum return on preferred stock is limited to a specific dividend, which is accorded to the rate of dividends on the invested amount. Dividends on preferred shares are declared and paid at the discretion of the board of directors.

A corporation can't claim a deduction of dividends paid on preferred but is eligible to claim a deduction in the corporation's tax returns in case of interest paid on debt.

We can calculate the maximum returns based on the following data:

Details:

Number of Preference Shares: 500

Par Value of Preference Share: $ 100

Percentage of Preference Share: 10.50 %

Maximum Returns to the Preference Share Hodler: ( $ 100 x 500 shares) / 10.5 % = $ 5,250/-

Preferred Stock's Holder Claim

A preferred stockholder's claim on assets at the time of liquidation comes after that of creditors but before that of common stockholders.

Typically, this claim is limited to the par value of the stock; for example, if a preferred stock's par value is $500, the investor will be entitled to a maximum of $500 in principal settlement.

The omission of a dividend will not result in a default of the obligation or insolvency of the company.

The board of directors has full power to omit a preferred stock dividend if it so chooses. Even though preferred stocks carry a stipulated dividend, the actual payment of a dividend is a discretionary rather than a fixed obligation of the company. despite this, the dividend is not a fixed obligation.

Benefits of Preferred Stock

One of the key benefits of preferred stock is that it offers a higher priority claim on assets and earnings compared to common stock. This means that if a company faces financial difficulties and needs to liquidate its assets, preferred shareholders would be paid before common shareholders.

Another advantage of preferred stock is that it often pays a fixed dividend, providing investors with a predictable income stream. Additionally, preferred shareholders may also benefit from potential capital appreciation if the price of the stock increases over time.

Risks of Preferred Stock

While preferred stock has its advantages, it also comes with its own set of risks. One of the main risks is interest rate risk. Since preferred stock prices are sensitive to changes in interest rates, a rise in interest rates could lead to a decline in the value of preferred stock.

Another risk is the lack of voting rights. Unlike common shareholders, preferred shareholders typically do not have a say in company decisions, which could be a disadvantage if the company's management makes decisions that are not in the best interest of shareholders.

How Does Preferred Stock Compare to Common Stock?

Preferred stock differs from common stock in several ways. While both types of stock represent ownership in a company, preferred stockholders do not usually have voting rights, whereas common shareholders typically do.

Additionally, preferred stockholders receive a fixed dividend, while common shareholders' dividends can vary based on the company's performance.

Is Preferred Stock Right for You?

Whether the preferred stock is a suitable investment for you depends on your individual financial goals and risk tolerance. If you are seeking a stable income stream and are willing to forgo voting rights, preferred stock may be worth considering.

However, it is important to carefully weigh the risks and benefits before investing.

Conclusion

Preferred stock can be a valuable addition to your investment portfolio, offering a fixed income stream and priority claim on assets. However, it is essential to understand the risks involved and consider whether preferred stock aligns with your investment objectives.

By carefully evaluating your options, you can make informed decisions that help you achieve your financial goals.