Preferred Dividend Coverage: Financial Metric Definition and Calculation

Preferred Dividend Coverage explains how well a firm can meet its preferred dividend obligations using its net income after interest and taxes, but before common stock dividends.

Preferred Dividend Coverage is a financial metric used to determine how many times a company’s earnings can cover its preferred dividend obligations. It is calculated by dividing net income after interest and taxes, but before common stock dividends, by the dollar amount of preferred stock dividends.

Formula and Calculation

The formula for Preferred Dividend Coverage is:

$$ \text{Preferred Dividend Coverage} = \frac{\text{Net Income after Interest and Taxes but before Common Stock Dividends}}{\text{Preferred Stock Dividends}} $$

This ratio indicates the company’s ability to pay its preferred dividends from its earnings.

Types and Special Considerations

• Consistent Earnings: Companies with stable and predictable earnings typically exhibit higher and more stable Preferred Dividend Coverage ratios.
• Volatile Earnings: Firms with fluctuating earnings may show variance in their Preferred Dividend Coverage, indicating potential risk to preferred dividend payments.
• Strategic Considerations: High coverage ratios might reflect financial stability and prudent management, while very high ratios might suggest retained earnings that could potentially be distributed as dividends or used for growth investments.

Example Calculation

Suppose a company has net income after interest and taxes (but before paying common stock dividends) of $10 million, and its preferred stock dividend obligation is $2 million. The Preferred Dividend Coverage ratio would be:

$$ \text{Preferred Dividend Coverage} = \frac{10,000,000}{2,000,000} = 5 $$

This means the company can cover its preferred dividends 5 times over with its current earnings.

Historical Context and Applicability

Preferred Dividend Coverage became more significant as preferred stocks gained popularity in the 19th and 20th centuries. Investors and analysts use this metric to assess the risk associated with preferred dividends, which have priority over common stock dividends in the event of a liquidation but are not guaranteed.

Comparisons and Related Terms

• Dividend Coverage Ratio: Similar to Preferred Dividend Coverage but includes both common and preferred dividends.
• Interest Coverage Ratio: Indicates how well a company can meet interest obligations, not dividends.
• Earnings Per Share (EPS): Profit allocated to each outstanding share of common stock, indicating overall profitability but not specific to preferred dividends.

FAQs

Q: Why is Preferred Dividend Coverage important?

A: It helps investors assess the ability of a company to pay its preferred dividends and indicates financial health and dividend safety.

Q: What is a good Preferred Dividend Coverage ratio?

A: Higher ratios (e.g., above 2-3) generally indicate better financial stability and lower risk of missing preferred dividend payments.

Q: How does Preferred Dividend Coverage differ from Dividend Coverage Ratio?

A: While Preferred Dividend Coverage focuses solely on preferred dividends, the Dividend Coverage Ratio considers both common and preferred dividends together.

References

• Investopedia, “Preferred Dividend Coverage Ratio”
• Corporate Finance Institute, “Dividend Coverage Ratio”
• Financial Management Textbooks, Various Authors

Summary

Preferred Dividend Coverage is a crucial financial metric for evaluating a company’s ability to meet its preferred dividend obligations. By understanding and calculating this ratio, investors and analysts can better assess the financial health and dividend safety of a corporation. This measure is essential for making informed investment decisions, particularly with preferred stocks, which have unique risk and return characteristics.