What Are Preferred Dividends & How Do They Work?

Dividends represent a portion of a company’s earnings distributed to its shareholders. These distributions are typically made periodically, often quarterly or annually, and serve as a return on investment for those who own the company’s stock. The board of directors determines whether to issue dividends, the amount, and the timing of these payments. Dividends are paid from a company’s net profits or retained earnings, and they are not considered an expense on the income statement.

Understanding Preferred Shares

Preferred shares constitute a distinct class of ownership in a company. Unlike common shares, preferred shares usually do not carry voting rights, meaning their holders do not typically participate in company governance or decisions like electing the board of directors. This differentiates them from common stock, which typically grants voting privileges. Preferred stock is often considered a hybrid security, blending features of both equity and debt.

Preferred shares have a fixed dividend rate, declared in advance, providing a predictable income stream for investors, contrasting with the variable nature of common stock dividends. Preferred shareholders also hold a higher claim on a company’s assets and earnings than common shareholders. In liquidation or bankruptcy, preferred shareholders are paid before common shareholders, though they rank below bondholders and other creditors. This priority makes preferred stock generally less risky than common stock. Companies often issue preferred stock to raise capital, committing to these regular dividend payments in return for the investment.

Characteristics of Preferred Dividends

Preferred dividends have a fixed rate, often expressed as a percentage of the stock’s par value or as a specific dollar amount per share. This rate is determined at the time the preferred stock is issued and provides investors with a predictable income stream. For instance, a preferred stock with a $100 par value and an 8% dividend rate would pay $8 per share annually.

Preferred dividends have priority of payment. Preferred shareholders must receive their declared dividends before any can be distributed to common shareholders. This means that if a company is facing financial constraints and cannot afford to pay all its dividends, preferred shareholders are paid first. This offers security for preferred investors during financial difficulty.

Preferred dividends are generally paid on a regular schedule, often quarterly or annually, providing consistent cash flow. For individual investors in the U.S., they may be classified as “qualified” dividends and taxed at lower capital gains rates, provided certain holding period requirements are met. Otherwise, they are taxed at ordinary income tax rates.

Categories of Preferred Dividends

Preferred dividends can be structured with various features that impact how and when payments are received, leading to different categories.

Cumulative Preferred Dividends

Cumulative preferred dividends accumulate as “dividends in arrears” if missed. These unpaid amounts must be fully satisfied before any dividends can be paid to common shareholders, ensuring that they will eventually receive all promised dividend payments.

Non-Cumulative Preferred Dividends

Non-cumulative preferred dividends do not accumulate if a payment is missed. If a company’s board of directors decides not to declare a dividend for non-cumulative preferred shares in a given period, that payment is generally forfeited by the shareholders. The company is not obligated to make up for these omitted payments in subsequent periods. Holders only have a claim on the current period’s declared dividends.

Participating Preferred Dividends

Participating preferred dividends offer potential for additional payments beyond the fixed rate. Shareholders receive their regular fixed dividend, and they may also receive an extra dividend payment if the company’s profits exceed a certain level or if common shareholders receive dividends above a specified amount. This “participation” allows them to share in the company’s success beyond their initial fixed return.

Non-Participating Preferred Dividends

Non-participating preferred dividends limit the shareholder to only the fixed dividend rate. These shareholders do not receive any additional payments, even if the company experiences exceptional profits or distributes higher dividends to common shareholders. Most preferred stock issued is non-participating, meaning investors receive the stated fixed dividends and no more.

Preferred Dividends Compared to Common Dividends

Preferred dividends are fixed, providing a stable income stream regardless of company profitability. Common dividends are variable; their amounts and frequency change based on financial performance and board discretion. A company may reduce or eliminate common dividends during tough economic times.

Preferred shareholders have a higher claim on earnings, receiving dividends before common shareholders. If a company cannot afford to pay all dividends, preferred shareholders take precedence. Common shareholders are last in line.

Preferred shareholders generally do not have voting rights, unlike common shareholders who can influence company decisions. This trade-off means preferred shareholders forgo voting power for dividend stability and payment priority. Preferred stock is generally less volatile, appealing to income-seeking investors. Common stock, while riskier, offers greater potential for capital appreciation.