What Is Preferred Stock and How Does It Work?

Preferred stock is a unique type of equity that represents ownership in a company. It grants the holder a claim on the company’s income and assets. While sharing characteristics with common stock, preferred stock also incorporates features typically associated with debt instruments. This blend of attributes makes preferred stock a hybrid security, offering a distinct investment profile.

Fundamental Characteristics

Preferred stock typically offers fixed dividend payments, usually expressed as a percentage of the stock’s par value or a specific dollar amount. These dividends are often paid on a regular schedule, such as monthly or quarterly. The fixed nature of these payments provides a more predictable income stream for investors.

A significant feature of preferred stock is its priority in receiving dividends. Preferred stockholders must receive their declared dividends before any dividends can be distributed to common stockholders. This preferential treatment also extends to a company’s liquidation, where preferred stockholders have a higher claim on the company’s assets than common stockholders.

In a liquidation scenario, preferred stockholders are paid from the company’s remaining assets after creditors and bondholders have been satisfied, but before common stockholders receive any distribution. This position offers a layer of security not afforded to common equity holders. However, preferred stock generally does not grant voting rights, meaning holders typically cannot influence corporate governance or major company decisions.

The terms of preferred stock can vary, with some issues being perpetual. This means there is no fixed date when the initial capital is returned to shareholders, similar to common stock.

Distinction from Common Stock

Preferred and common stock differ in several key aspects. Preferred stock typically pays fixed dividends, offering a consistent income stream. Common stock dividends, however, are variable and depend on the company’s profitability and the discretion of its board of directors, meaning they can fluctuate or even be suspended.

Preferred stockholders also hold a superior position regarding payment priority. They receive dividends before common shareholders. This priority also extends to asset distribution during a company’s liquidation or bankruptcy, where preferred stockholders are paid out before common stockholders, though after bondholders and other creditors.

Common stock generally grants shareholders voting rights, allowing them to participate in important corporate decisions, such as electing board members or approving major transactions. Conversely, preferred stock usually does not confer voting rights, limiting the influence preferred shareholders have over company operations.

The potential for capital appreciation also differs. Preferred stock prices tend to be less volatile than common stock prices and generally have limited growth potential. Common stock offers a greater opportunity for price appreciation based on the company’s performance and market conditions, reflecting its higher risk and potential reward profile.

Variations of Preferred Stock

Several variations of preferred stock exist, each with distinct features:

Cumulative Preferred Stock

Cumulative preferred stock includes a provision where any missed dividend payments accumulate over time. These accumulated dividends, known as “dividends in arrears,” must be fully paid to cumulative preferred shareholders before any dividends can be distributed to common stockholders.

Non-Cumulative Preferred Stock

Non-cumulative preferred stock does not accrue missed dividends. If a company’s board of directors decides not to pay a dividend in a given period, that payment is simply forgone by non-cumulative preferred shareholders. This characteristic makes non-cumulative preferred stock generally less attractive to income-focused investors.

Convertible Preferred Stock

Convertible preferred stock offers holders the option to exchange their preferred shares for a fixed number of common shares of the same company. This conversion feature allows investors to potentially benefit from an increase in the common stock’s price while retaining the income and priority benefits of preferred stock until conversion. The terms of conversion, including the ratio and timing, are specified at issuance.

Callable Preferred Stock

Callable preferred stock grants the issuing company the right to repurchase the shares from investors at a predetermined price and date. This feature benefits the company by allowing it to redeem the shares, often to reduce its dividend obligations or if interest rates decline, enabling it to issue new preferred stock at a lower dividend rate. From the investor’s perspective, this means the stock can be “called away,” potentially limiting its upside.

Participating Preferred Stock

Participating preferred stock provides its holders with the opportunity to receive additional dividends beyond their fixed preferred dividend. This extra payment is typically contingent on certain conditions, such as the company’s profits exceeding a specified level or common stock dividends reaching a particular threshold. This allows participating preferred shareholders to share in the company’s success beyond their regular fixed payments.