What Is Preferred Stock and How Does It Work?

A stock represents a unit of ownership in a company, granting the holder a fractional stake in the business. This ownership can entitle shareholders to a portion of the company’s earnings, a claim on assets, or voting power on corporate matters. Stock ownership allows individuals and entities to participate in a company’s financial success and provides businesses with a means to raise capital for operations and growth.

Defining Preferred Stock

Preferred stock stands as a distinct class of ownership, blending attributes typically found in both debt and equity instruments.

Key Characteristics of Preferred Stock

Preferred stock is characterized by several core attributes that set it apart in the financial landscape. One prominent feature is the fixed dividend payment. Preferred shareholders typically receive dividends at a predetermined rate, often expressed as a percentage of the stock’s par value, which remains constant regardless of the company’s fluctuating earnings. These dividends are usually paid at regular intervals, such as quarterly or monthly, offering a stable income stream to investors.

In the event of a company’s liquidation, preferred stockholders hold a significant advantage through their liquidation preference. This means that if a company is sold or goes bankrupt, preferred shareholders are paid out from the company’s assets before common stockholders receive any distribution. This priority helps to safeguard the initial investment of preferred shareholders to a greater extent than that of common shareholders.

A common trait of preferred stock is the typical absence of voting rights. Unlike common stockholders who generally have the right to vote on corporate decisions, such as electing board members or approving major company actions, preferred shareholders usually do not possess such voting power. This lack of voting influence is often a trade-off for the preferred treatment in dividends and liquidation. Furthermore, preferred stock may include features like callability, allowing the issuing company to repurchase the shares at a set price, or convertibility, giving holders the option to convert their preferred shares into common stock under certain conditions.

Preferred Stock Versus Common Stock

Preferred stock and common stock differ in several key aspects:

Dividends and Liquidation Priority: Preferred stock typically offers fixed dividend payments and has a higher claim on company assets during liquidation, receiving payments before common stockholders. Common stock dividends are variable and not guaranteed, and common stockholders have a residual claim on assets after preferred shareholders.
Voting Rights: Common stock generally grants shareholders voting rights on corporate matters, allowing them to influence company decisions. Preferred stock usually carries no voting rights.
Capital Appreciation: Common stock generally offers greater potential for price growth over time, as its value can increase significantly with the company’s success. Preferred stock tends to have more limited capital appreciation potential, as its price is less volatile and more influenced by interest rate movements.

Types of Preferred Stock

Preferred stock comes in several forms, each with distinct features impacting dividend payments and investor rights.

Cumulative and Non-Cumulative Preferred Stock

Cumulative preferred stock is a common type where, if a company misses a dividend payment, those unpaid dividends accumulate and must be paid to cumulative preferred shareholders before any dividends can be distributed to common stockholders. This provision offers greater security for investors, as all missed payments, also known as dividends in arrears, must be settled eventually. Conversely, non-cumulative preferred stock does not require the company to make up for missed dividend payments; if a dividend is skipped, that payment is permanently lost to the shareholder.

Convertible Preferred Stock

Convertible preferred stock provides shareholders with the option to convert their preferred shares into a predetermined number of common shares. This feature allows investors to benefit from potential capital appreciation if the common stock’s value increases, while still enjoying the stable income and priority of preferred shares until conversion. The decision to convert typically rests with the shareholder, allowing them to participate in the common stock’s growth.

Callable Preferred Stock

Callable preferred stock includes a provision that allows the issuing company to repurchase the shares from investors at a specified price after a certain date. Companies might exercise this call option if interest rates decline, enabling them to reissue new preferred shares at a lower dividend rate. This feature provides flexibility for the issuing company but can limit the investor’s potential for long-term income from that specific preferred stock.

Participating Preferred Stock

Participating preferred stock offers shareholders the ability to receive their fixed preferred dividend and, under certain conditions, an additional dividend. This extra dividend is often tied to the company’s performance, such as achieving certain sales or earnings targets, or if common stock dividends exceed a specified amount. In liquidation, participating preferred shareholders may also receive their initial investment back and then share in the remaining proceeds with common stockholders on a pro-rata basis.

Reasons for Issuing and Investing in Preferred Stock

Companies issue preferred stock for several strategic reasons, primarily to raise capital without diluting the voting control of existing common shareholders. Since preferred stock typically does not carry voting rights, it allows a company to secure funding while maintaining the current ownership structure and decision-making power. This hybrid security also offers flexibility compared to pure debt or equity, as preferred dividends can be deferred without triggering a default, unlike interest payments on debt. Issuing preferred shares can also help a company maintain a lower debt-to-equity ratio, making its financial statements appear more attractive to potential lenders and investors.

For investors, preferred stock presents an appealing option due to its stable income generation. The fixed dividend payments provide a predictable cash flow, which can be particularly attractive to income-focused investors. Preferred stock also carries lower risk compared to common stock, primarily due to its priority in receiving dividends and its preferential claim on assets during liquidation. This makes it a suitable choice for risk-averse investors seeking more stability. Preferred stock dividends are often classified as “qualified dividends” for tax purposes, taxed at lower long-term capital gains rates, provided specific holding period requirements are met.