Preferred Stock is a class of ownership in a corporation that has a higher claim on its assets and earnings compared to common stock. Preferred stockholders receive dividends before common stockholders and have a higher priority during asset distribution if the company dissolves.
Characteristics of Preferred Stock
Preferred stock typically offers non-voting rights, distinguishing it from common stock which generally provides voting privileges. Preferred stockholders are often guaranteed a fixed dividend, which must be paid out before any dividends are distributed to common stockholders.
Types of Preferred Stock
Cumulative Preferred Stock
Cumulative preferred stock ensures that any missed dividend payments are accumulated and paid out to preferred stockholders first before common stock dividends are issued.
Non-Cumulative Preferred Stock
Non-cumulative preferred stock does not include the accumulation feature. If dividends are not declared in any given year, preferred stockholders have no right to claim those dividends in the future.
Participating Preferred Stock
Participating preferred stock allows holders to receive dividends at a standard rate plus an additional dividend based on certain conditions, often contingent on the dividends received by common stockholders.
Convertible Preferred Stock
Convertible preferred stock grants the option to convert preferred shares into a predetermined number of common shares. This type can be advantageous if the company’s common stock price rises significantly.
Historical Context
The concept of preferred stock dates back to the 19th century as a financial instrument developed to attract investments by offering distinct benefits over common stock. Since then, it has become an important tool in corporate finance, providing a balance between debt and equity in a company’s structure.
Examples and Applications
Consider a corporation offering both common and preferred stock. If the corporation declares a dividend, preferred stockholders receive their specified dividends first. For example, if preferred stock has a dividend of $2 per share and the company distributes $10,000 in dividends, the entire amount would first cover the preferred shareholders before any are distributed to common shareholders.
Special Considerations
Preferred stock can be more stable in terms of dividends compared to common stock. However, it typically does not have the same growth potential because preferred stock does not usually participate in the company’s profitability beyond the assigned dividends. Preferred stock may also be callable, meaning the issuing company can repurchase the shares at a predetermined price.
Comparisons with Common Stock
Dividends
- Preferred Stock: Guaranteed fixed dividends.
- Common Stock: Dividends vary and are not guaranteed.
Voting Rights
- Preferred Stock: Generally, no voting rights.
- Common Stock: Typically includes voting rights.
Priority in Liquidation
- Preferred Stock: Higher priority over common stock.
- Common Stock: Last in line during liquidation.
Related Terms
- Capital Stock: The total value of stock authorized and issued by a corporation, encompassing both common and preferred stock.
- Dividends: A distribution of a portion of a company’s earnings to stockholders, typically in the form of cash or additional shares.
- Assets: Resources owned by a company, which are used to produce value. In case of liquidation, preferred stockholders have a prior claim over these assets.
FAQs
What are the benefits of holding preferred stock?
Can preferred stock dividends be skipped?
Is preferred stock a good investment?
References
- Brigham, E. F., & Ehrhardt, M. C. (2013). Financial Management: Theory & Practice. Cengage Learning.
- Ross, S. A., Westerfield, R. W., & Jordan, B. D. (2016). Corporate Finance. McGraw-Hill Education.
Summary
Preferred stock serves as a middle ground between common stock and bonds, offering fixed dividends and priority in asset distribution while typically forgoing voting rights. It can be a valuable investment for those prioritizing steady income and lower risk in the event of a company’s financial difficulties.
