- Distinguish between characteristics of common and preferred stock
There are three main differences between common stock and preferred stock.
- Preferred shareholders have priority over a company’s income, meaning they are paid dividends before common shareholders.
- In the event a company dissolves, preferred shareholders are paid after creditors but before common stockholders.
- Preferred stock functions similarly to bonds since with preferred shares, investors are promised a fixed return on investment.
Dividends
Cash dividends are payouts of profits from retained earnings to stockholders. When a company declares a dividend, it must pay the preferred stock dividends first. There are two types of preferred stock with regard to dividends: cumulative and non-cumulative.
- Cumulative preferred stock means that all of the dividends promised but not paid in the current and past years have to be made up before common stockholders can be paid.
- Non-cumulative preferred stock means only the current preferred stock dividends have to be paid before common stockholders can be paid.
Liquidation
The preferred claim over a company’s income and earnings is most important during times of insolvency. Common stockholders are last in line for the company’s assets. This means when the company goes out of business, it sells off all of its assets and then first pays off all creditors and bondholders, then the preferred stockholders receive a payment up to the par value of the preferred stock, and then common stockholders get whatever is left, which is often nothing.
Return on Investment
Because preferred stocks’ par values are fixed and do not change, preferred stock dividend yields are more static and less variable than common stock dividend yields. You calculate a preferred stock’s dividend yield by dividing the annual dividend payment by the par value.
If a share of preferred stock has a par value of $100 and pays annual dividends of $5 per share, the dividend yield would be 5%.
Because par values are not the same as trading values, you have to pay attention to the trading price of preferred shares as well. If the preferred stock from the example above is trading at $110, its effective dividend yield would decrease to 4.5%. Like bonds, preferred shares also have a par value which is affected by interest rates. When interest rates rise, the value of the preferred stock declines, and vice versa.
Convertibility
Preferred stock may also have a convertibility feature which gives the holder the right to convert the preferred shares to common shares. Venture capitalists often invest in startups using non-publicly traded preferred stock instead of loaning money, and then, when the company goes public, the venture capitalist converts the preferred stock to common.
For example, if the preferred stock has a conversion ratio of 5:1, every share of preferred stock could be swapped for 5 shares of common stock.
Assume an investor bought 1,000 preferred shares for $75 with a conversion ratio of 5:1 and the company went public with the common stock trading at $38 per share. By converting the preferred shares to common, the investor turns a $75,000 investment into $190,000 and now has voting rights as well.
In summary, preferred stock is considered a hybrid between debt and equity. It has a fixed rate of return and priority in liquidation, but the company doesn’t have to pay back the principal, as it would with debt.