What is Preferred Stock?

Kathleen Chaykowski
Covered finance and business at Forbes and The Wall Street Journal. BA, Stanford University.
Definition:

Preferred stock is a breed of stock that gives investors a higher claim to payments from a company (aka dividends), but usually no voting rights.

🤔 Understanding preferred stock

Preferred stock is one of two main types of stock that gives investors first dibs on receiving income from the company, known as dividends, depending on how many shares the investor owns. Investors who own preferred shares are also usually paid before investors who own common shares if a company goes bankrupt (after creditors are paid), and sometimes have the option to convert their shares into common shares. Preferred shares don’t come with all of the perks though — they typically come with little to no voting rights, meaning these shareholders don’t get a say in decisions like selecting board members or other corporate events like mergers, acquisitions, or stock splits.

Example

Let’s take a look at Ford’s stock as an example. As of January 31, 2019, 116,764 investors owned common stock in the company, and just three investors owned preferred stock. According to the company’s 2018 annual report, both preferred and common stockholders were paid a dividend of 15 cents per share for the fourth quarter of 2018. For the first quarter, both types of shareholders received 28 cents per share, while in the second and third quarters, both common and preferred shareholders received 15 cents per share. Source: Ford’s 2018 Annual Report.

Takeaway

Preferred stock is like a VIP pass at a concert, while common stock is like a ticket for general admission…

Both categories of stock are slices of ownership in a company, however preferred shares are a less prevalent type of stock and have characteristics of a bond. They give investors a prioritized spot in line to receive income from the company (aka dividends) before common stockholders. Preferred shares, however, usually come with little to no voting rights.

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What’s the difference between common stock and preferred stock?

Common stock and preferred stock are the two main categories of stocks (which represent ownership or equity in a company). These two categories of stock are both purchased through brokerage firms, but they have some key differences:

  1. Prevalence: Common stock is much more common (like the name suggests) than preferred stock . The bulk of preferred stock is issued by banks or even insurance companies. Many blue chip (aka well-established, generally stable) companies that offer dividends on common stock don’t issue preferred stock at all.
  2. Claim on dividends: Companies that issue preferred and common stock have an obligation to pay preferred shareholders dividends on a planned schedule, before common shareholders receive any income. If a company is struggling to pay dividends, preferred shareholders will get theirs first.
  3. Claim on assets: If a company files for bankruptcy or has other types of trouble, creditors (aka bond holders) will be paid first, but next in line are preferred shareholders, while common shareholders are last. If a company goes under, preferred shareholders generally have more protections than common shareholders.
  4. How they act: Preferred shares, in general, act more like bonds than stock. Preferred shares tend to trade at a stable price, without substantial potential for capital gain from stock price fluctuations, because the company’s share price generally doesn’t affect their value. Instead, investors seek income from preferred stock through dividends. To top things off, preferred shares are rated for financial strength similarly to the way bonds are, even if they don’t offer the same degree of investment protection in terms of liquidation preference. Although it’s not common, preferred shares can also come with term limits or expiration, like bonds do, meaning the ownership contract has a set length, for example 5 years. Some preferred shares contain callabe clauses that allow the issuer to recall the shares.
  5. Voting rights: Common stock tends to come with voting rights, meaning shareholders can partake in important decisions like deciding who gets voted onto the board of directors, whether mergers and acquisitions take place, and other big corporate events. Preferred shares usually don’t come with voting rights.
  6. Conversion: Preferred shares sometimes come with the option for shareholders to convert them into common shares. Meanwhile, common shares generally can’t be converted into preferred shares.

It’s important to read the certificate of designation to know how a preferred share operates. Investors can look at the Securities and Exchange Commission’s public documents database called EDGAR to see what information companies issuing preferred shares have shared about their preferred stock, as well as other financial disclosures related to the stock.

Can a single stock issue different types of preferred shares?

Yes, a single stock can issue preferred stock in different classes. This means that a company could make different groups of preferred shares available with different dividend values. In preferred stock listings (places where investors can see which shares are available to buy), preferred shares will be listed based on their dividend yield, which is a ratio that shows the value of a dividend compared to a stock’s share price. For example, if a stock has a relatively low share price and a high dividend, it might have a high dividend yield relative to other stocks. Similarly, a stock with an average dividend and a high stock price might have a low dividend yield compared to other stocks.

How are preferred stocks rated?

Many preferred stocks are rated by agencies like Standard & Poor’s Corporation and Moody’s Investors Service. The ratings are typically meant to help disclose the creditworthiness of the issuer (in this case, the company making preferred shares available), as well as the company’s ability to pay interest it owes.

On a Standard & Poor’s rating scale, shares rated BBB or higher are usually considered to be investment grade (meaning the rating agency believes the issuer's prompt payment of interest and principal (at maturity) is considered relatively safe), while preferred shares rated below BBB- are considered to be higher risk than those rated higher.

On the Moody’s scale, preferred shares rated Baa3 and above are generally seen as investment grade, while stocks rated lower than Baa3 are usually considered to be below investment grade.

Keep in mind that credit ratings do not remove market risk and are subject to change.

What are the different categories of preferred stock?

Preferred shares tend to land in five different categories:

  1. Cumulative preferred shares: If companies defer on paying dividends on these preferred shares, the dividends will accrue, and the company will have to pay these dividends to preferred shareholders before they pay dividends to any common stockholders.
  2. Non-cumulative preferred shares: These are preferred shares where, if the issuing company stalls on paying dividends, they won’t accrue, and the shareholder might never get them.
  3. Trust-preferred shares: These preferred shares are offered when the company sets up a trust and issues preferred shares through that trust. The shares are funded by the debt securities of the company, and mature at the same time as the debt securities that fund them.
  4. Convertible preferred stock: These preferred shares can be converted into a specific number of common shares.
  5. Exchangeable preferred stock: These preferred shares can be exchanged for another type of security.

Why does a company issue preferred stock?

Companies issue preferred stock, or other securities such as common stock or bonds, as a way of raising capital to run their business or invest in new initiatives they think will drive future growth. Companies are sometimes attracted to issuing preferred shares over other types of securities for a few different reasons:

  1. Agreement length: Preferred shares might have a shorter maturity date than those of bonds, meaning, the preferred shareholder’s certificate of ownership in the preferred shares often span shorter periods of time than those of bonds.
  2. Consistency: The value of preferred shares usually doesn’t fluctuate as much as that of common stock. This, combined with preferred shares’ planned dividend schedule, can sometimes lead companies to issue them over common stock or bonds.
  3. Easing debt fears: If a company fails to meet a bond payment, that company could be at risk of defaulting on its issue, and as a result, face bankruptcy. By contrast, companies that issue preferred shares can defer their dividend payments, which gives them more flexibility to pay the dividends they owe when they have the cash.

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