What Is Preferred Stock? How Is It Different From Common Stock?
When You Should Prefer Preferred Stocks Over Common Ones
A preferred stock is a share of ownership in a public company. It has some qualities of a common stock and some of a bond. The price of a share of both preferred and common stock varies with the earnings of the company. Both trade through brokerage firms. Bond prices on the other hand, vary with the company's ability to pay the bond it, as rated by Standard & Poor's.
Preferred stocks pay a dividend like common stock.
The difference is that preferred stocks pay an agreed-upon dividend at regular intervals. This quality is similar to that of bonds. Common stocks may pay dividends depending on how profitable the company is. Preferred stock dividends are often higher than common stock dividends. The dividend can be adjustable and vary with Libor or it can be a fixed amount that never varies.
Preferred stocks are also like bonds in that you’ll get your initial investments back if you hold them until maturity. That's 30 years to 40 years in most cases. Common stock values can fall to zero. If that happens, you'd get nothing.
Companies that issue preferred stocks can recall them before maturity by paying the issue price. Like bonds and unlike stocks, preferred stocks do not confer any voting rights.
When You Should Buy Preferred Stocks
You should consider preferred stocks when you need a steady stream of income.
This is true in particular when interest rates are low. It’s because preferred stock dividends pay a higher income stream than bonds. Although lower, the income is more stable than stock dividends.
You should sell them when interest rates rise. This is because that’s when they start to lose value. It’s true with bonds as well.
The fixed income stream becomes less valuable as interest rates push up the returns on other investments.
Preferreds could also lose value when stock prices rise. That's because the company may call them in. It means they buy the preferred stocks back from you before the prices get any higher.
Preferred Stocks Versus Common Stocks
This table illustrates the difference between preferred stocks, common stocks and bonds.
|Ownership of Company||Yes||Yes||No|
|Price of Security Is Based on:||Earnings||Earnings||S&P Rating|
|Value if Held to Maturity||Full||Varies||Full|
|Order Paid if Company Defaults||Second||Third||First|
Types of Preferred Stocks
Convertible preferred stocks have the option of being converted into common stock at some point in the future. What determines when this happens? Three things:
- The corporation's Board of Directors may vote for a conversion.
- You might decide to convert. You would only exercise this option if the price of the common stock is more than the net present value of your preferreds. The net present value includes the expected dividend payments and the price you would receive when the life of the preferred is over.
- The stock might have automatically converted on a predetermined date.
Cumulative preferred stocks allow companies to suspend dividend payments when times are bad. But they must pay all the missed dividend payments when times are good again. In fact, they must do this before they can make any dividend payments to common stockholders. Preferred stocks without this advantage are called non-cumulative stocks.
Redeemable preferred stocks gives the company the right to redeem the stock at any time after a certain date. The option usually describes the price the company will pay for the stock. The redeemable date is often not for a few years. These stocks pay a higher dividend to compensate for the added redemption risk. Why? The company could call for redemption if interest rates drop. They would issue new preferreds at the lower rate, and pay a smaller dividend instead.
That means less profit for the investor.
Why Companies Issue Preferred Stock
Companies use preferred stocks to raise capital for growth. The corporation’s ability to suspend the dividends is its biggest advantage over bonds. It just requires a vote of the board. They run no risk of being sued for default. If the company doesn't pay the interest on its bonds, it defaults.
Companies also use preferred stocks to transfer corporate ownership to another company. For one thing, companies get a tax write-off on the dividend income of preferred stocks. In fact, they don't have to pay taxes on the first 80 percent of income received from dividends. individual investors don't get the same tax advantage. Second, companies can sell preferred stocks quicker than common stocks. It’s because the owners know they will be paid back before the owners of common stocks will.
This advantage was why the U.S. Treasury bought shares of preferred stocks in the banks as part of Troubled Asset Relief Program. It capitalized the banks so they wouldn't go bankrupt. At the same time, the Treasury wanted to protect the government. Taxpayers would get paid back before the common shareholders if the banks defaulted at all.
Preferred stocks are often issued as a last resort. Companies use it after they've gotten all they can from issuing common stocks and bonds. That's because preferred stocks are more expensive than bonds. The dividends paid by preferred stocks come from the company's after-tax profits. These expenses are not deductible. The interest paid on bonds is tax-deductible. This runs cheaper for the company. (Source: “The Power of Preferred Stocks,” Motley Fool, April 24, 2001.)