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Preferred stock is a specific type of stock which has very different characteristics from common stock. Like common stock, proceeds from the sale of preferred stock are recorded by the company on its balance sheet as equity; or, an ownership interest. For all practical purposes, however, investors consider preferred stocks to be another type of debt security; specifically, one which normally pays a fixed return in the form of quarterly dividends instead of semi-annual interest payments, as some bonds do.
Because preferred stocks are, in fact, equity instruments, they have three important differences from bonds. First, they are junior to the company’s debt obligations. Every security that a company issues has a specific ranking order, from the most senior to the most junior. In the event that the company doesn’t generate enough cash to service all of its debts, this ranking order will determine who receives payment first. Interest payments are made first to the most senior debt holder, then to the next, and so on until the available cash is exhausted. Being 
company ownership, common stocks are always the most junior securities, with preferred stocks ranking between the most junior debt security and the company’s common stock.
Second, unlike debt instruments, the company isn’t legally obligated to make dividend payments to its preferred stockholders. Missing an interest payment on a bond will cause a default because it is a debt. Bondholders can then claim breach of contract and force the company into involuntary bankruptcy. They can also have the company’s board of directors or management team replaced. Missing a dividend payment, however, is not a breach of contract and, thus, will not cause a default. A company will usually strive to make its dividend payments to preferred stockholders nonetheless, because generally, the company is prohibited from making dividend payments to its common stockholders as well as to company managers until its preferred stockholders have been paid.
The third difference between preferred stocks and bonds is that dividends don’t accrue between dividend payment dates. When bonds trade, they trade with accrued interest. An investor who buys a bond between interest payment dates must pay the seller not only the price of the bond, but also the interest that the bond has earned since the last interest payment date. Preferred stocks do not trade with accrued dividends. When an investor buys a preferred stock between dividend payment dates, the seller is not entitled to receive a partial or prorated dividend amount. Whoever owns the stock on the ownership day of record, known as the ex-dividend day, is entitled to receive any dividend payment, regardless of how long that investor has owned the stock.
Companies issue preferred stocks in order to strengthen their balance sheets. Since the proceeds from preferred stock sales are considered equity, they also improve the issuing company’s debt-to-equity ratio. Companies need to enhance their balance sheets for several reasons: to avoid violating the covenants of their loan agreements; to meet legally mandated debt-to-equity ratios (for regulated industries such as banking or insurance); and to provide the capital that’s necessary to support their expansion plans. While the issuance of either preferred or common stock will strengthen the balance sheet, preferred stocks must provide their investors higher dividends than common stocks because preferred stocks don’t offer the opportunity to share in the company’s growth. This is so that the company doesn’t dilute the ownership interest of the current common stockholders by the issuance of preferred stock.
Within the vast spectrum of financial instruments, preferred stocks occupy a unique place. Because of their characteristics, they straddle the line between stocks and bonds. Technically, they are equity securities, but they share many characteristics with debt instruments. Some investment commentators refer to them as hybrid securities.
Preferred stock is similar to common stock in that it entitles its owners to receive dividends which the firm must pay out of after-tax income. Moreover, the use of preferred stock as a source of financing does not increase the probability of bankruptcy for the firm. However, like the coupon payments on debt, the dividends on preferred stock are generally fixed. Also, the claims of the preferred stockholders against the assets of the firm are fixed as are the claims of the debtholders.
Preferred stock has the following features:
Since the preferred dividends are generally fixed, preferred stock can be valued as a constant growth stock with a dividend growth rate equal to zero. Thus, the price of a share of preferred stock can be determined using the following equation:
where
| Preferred Stock Valuation Example |
| Find the price of a share of preferred stock given that the par value is $100 per share, the preferred dividend rate is 8%, and the required return is 10%. Solution:
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Stock Valuation is more difficult than Bond Valuation because stocks do not have a finite maturity and the future cash flows, i.e., dividends, are not specified. Therefore, the techniques used for stock valuation must make some assumptions regarding the structure of the dividends.
A constant growth stock is a stock whose dividends are expected to grow at a constant rate in the forseeable future. This condition fits many established firms, which tend to grow over the long run at the same rate as the economy, fairly well. The value of a constant growth stock can be determined using the following equation:
where
| Constant Growth Stock Valuation Example |
| Find the stock price given that the current dividend is $2 per share, dividends are expected to grow at a rate of 6% in the forseeable future, and the required return is 12%. Solution:
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Many firms enjoy periods of rapid growth. These periods may result from the introduction of a new product, a new technology, or an innovative marketing strategy. However, the period of rapid growth cannot continue indefinitely. Eventually, competitors will enter the market and catch up with the firm.
These firms cannot be valued properly using the Constant Growth Stock Valuation approach. This section presents a more general approach which allows for the dividends/growth rates during the period of rapid growth to be forecast. Then, it assumes that dividends will grow from that point on at a constant rate which reflects the long-term growth rate in the economy.
Stocks which are experiencing the above pattern of growth are called nonconstant, supernormal, or erratic growth stocks.
The value of a nonconstant growth stock can be determined using the following equation:
where
| Nonconstant Growth Stock Valuation Example |
| The current dividend on a stock is $2 per share and investors require a rate of return of 12%. Dividends are expected to grow at a rate of 20% per year over the next three years and then at a rate of 5% per year from that point on. Find the price of the stock. Solution: There are 3 years of nonconstant growth, thus, T = 3. Before substituting into the formula given above it is necessary to calculate the expected dividends for years 1 through 4 using the provided growth rates.
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| Constant Growth Stock Price: | |
| Expected Return: |  |
| Nonconstant Growth Stock: | |
| Preferred Stock: | |
| Calculators: | Click Here |
Step 1
Learn what the differences are between preferred stock and common stock. Preferred stock takes priority over common stock when earnings are disbursed as dividends. Usually, dividends on preferred stock are higher, and are paid at regular intervals. The dividends are sometimes guaranteed. If the company has a bad year, and the dividends are not paid, this guarantee means that the payment will be made later but before any common stock dividends are paid. An important point to consider is that if the company becomes insolvent preferred stockholders are paid out of any company assets left after creditors are paid before common share stockholders receive any money.
Step 2
Understand the advantages when you buy preferred stock. Because preferred stock normally has higher and more regular dividends, it is less volatile than common stock and carries less risk. With a preferred stock that has a guaranteed dividend, it is often considered a fixed-income investment similar to a bond. At the same time, if a company grows, the stock value can appreciate. For many investors, this fixed-income characteristic makes preferred stock a good choice for long-term retirement investments (for example, as part of an IRA portfolio).
Step 3
Be aware of the disadvantages of preferred stock. While preferred stock carries less risk than common stock, it has more risk than bonds and may not offer a better income via dividends than the interest on bonds. In addition, preferred stock does not fall into the same classification for tax purposes. Unless the income is sheltered it will be taxed as regular income.
Step 4
Open a brokerage account. You need the same type of account that is used for buying common stock, and you place buy and sell orders the same way. You can open an account through your bank or use a full-service or discount brokerage.
Step 5
Research a company thoroughly before you purchase preferred stock just as you would for a common stock investment. Look for articles in business publications that discuss the company’s performance and prospects. Go to their website and study the information they provide for investors and order a copy of the company’s annual report.
Technically there is no exit from preferred stock -- simply a choice between going long or trading the security. If you choose to go long, the security becomes nearly a bond in a fixed income portfolio and your death is the exit strategy. If you trade, then you simply flip the security around dividend payments as to maximize gains; exiting upon sale. If you choose to be long, think like a bond-holder and build a ladder which provides fixed income. If you choose to be short/trader, keep an eye on dividend dates for your exits and play the charts.
Pretty simple, eh?
But there is one other exit: conversion. Most preferred stock allows one to convert their holding into commons and obtain profits via dilution. If you wish to do so, call your broker and have them work out the cert registration and conversion process. The discussion should explain how much you may profit.
Let’s assume you purchase 100 shares of XYZ Company convertible preferred stock on June 1, 2006. According to the registration statement, each share of preferred stock is convertible after January 1, 2007, (the conversion date) to three shares of XYZ Company common stock. (The number of common shares given for each preferred share is called the conversion ratio. In this example, the ratio is 3.0.)
If after the conversion date arrives XYZ Company preferred shares are trading at $50 per share, and the common shares are trading at $10 per share, then converting the shares would effectively turn $50 worth of stock into only $30 worth (the investor has the choice between holding one share valued at $50 or holding three shares valued at $10 each). The difference between the two amounts, $20, is called the conversion premium (although it is typically expressed as a percentage of the preferred share price; in this case it would be $20/$50, or 40%).
By dividing the price of the preferred shares ($50) by the conversion ratio (3), we can determine what the common stock must trade at for you to break even on the conversion. In this case, XYZ Company common must be trading at a minimum of $16.67 per share for you to seriously consider converting. So, if you're clever, you'll buy the preferred shares as cheap as possible and convert when the common shares are above cost/conversion ratio -- allowing you to own the three shares at discount to market (similar to a options call).
Convertible preferred shares trade like other stocks, but the conversion premium influences their trading prices. The lower the conversion premium, (that is, the closer the preferred shares are to being “in the money,”) the more the price of the preferred shares will follow the price movements of the common stock. The higher the conversion premium, the less the convertible preferred shares follow the common stock.
Usually, holders of convertible preferred can convert at any time after the conversion date, but sometimes the issuer can force conversion. Either way, converting preferred stock into common stock dilutes the common shareholders, which is why companies sometimes offer to buy back converted shares.
