Preferred Stock: Definition, vs. Common Stock, Types

When You Should Prefer Preferred Stocks Over Common Ones

preferred stock
Retired couples should consider preferred stock because of the higher income stream.. Photo: Davids' Adventures Photos/Getty Images

Definition: 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 each share of both preferred and common stock varies with the earnings of the company. Both trade through brokerage firms. Bond prices vary with the company's ability to pay it as rated by Standard & Poor's.

Preferred stocks pay a dividend like common stock.

But preferred stocks are like bonds in that they pay an agreed-upon dividend at regular intervals. Common stocks may pay dividends, but they vary depending on how profitable the company is. Preferred stock dividends are usually 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, if you hold them until maturity, you'll get your initial investments back. That's 30 to 40 years in most cases. Common stock values can fall to zero, in which case 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. That's especially true when interest rates are low.

That's because preferred stock dividends pay a higher income stream than bonds. The income is more stable than stock dividends, although lower. 

You should sell them when interest rates rise. It's because they start to lose value. That'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. That means they buy the preferred stocks back from you before stock prices get any higher. (Source: "How Preferreds Stack Up," Wall Street Journal, May 7, 2012.)

Preferred Stocks vs. Common Stocks

This table illustrates the difference between preferred stocks, common stocks, and bonds.

FeaturePreferred Common Bond
Ownership of CompanyYesYesNo
Voting RightsNoYesNo
Price of Security Is Based on:EarningsEarningsS&P Rating 
DividendsFixedVariesFixed
Value if Held to MaturityFullVariesFull
Order Paid if Company Defaults SecondThirdFirst

Types of Preferred Stocks

Convertible preferred stocks have the option to be converted into common stock at some point in the future. What determines when this happens? Three things:

  1. The corporation's Board of Directors may vote for a conversion.
  2. You might decide to convert. You would only exercise this option of 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.
  1. The stock might have automatically converted on a pre-determined date. (Source: Convertible Preferred Stock, Joshua Kennon, About Beginning Investing.)

Cumulative preferred stocks only allow companies to suspend dividend payments when times are bad. They must pay you 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 stock gives the company the right to redeem the stock any time after a certain date. The option usually describes the price the company will pay for the stock. The redeemable date is usually not for a few years. These stocks pay a higher dividend to compensate for the added redemption risk. Why? The company would call for redemption if interest rates drop. They would issue new preferreds at the lower rate, and pay a smaller dividend. That means less profit for the investor. 

Why Do Companies Issue Preferred Stock?

Companies use preferred stocks to raise capital for growth. Their biggest advantage over bonds is that the corporation can suspend the dividends. 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 shares to transfer corporate ownership to another company. For one thing, companies get a tax write-off on the dividend income of preferred stock. In fact, they don't have to pay taxes on the first 80% of income received from dividends. Unfortunately, individual investors don't get that same tax advantage. Second, companies can more quickly sell preferred stock than common stock. That's because owners know they will be paid back before the owners of common stock will.

That advantage was why the U.S. Treasury bought shares of preferred stock in the banks as part of TARP. It capitalized the banks so they wouldn't go bankrupt. At the same time, Treasury wanted to protect the government. Taxpayers would get paid back before the common shareholders if the banks defaulted after all.

Preferred stock is usually only issued as a last resort. Companies use it after they've gotten all they can from issuing common stock and bonds. That's because preferred stock is more expensive than bonds. The dividends paid by preferred stock comes from the company's after-tax profits. These expenses are not deductible. The interest paid on bonds is tax-deductible, and so is cheaper for the company. (Source: Motley Fool, The Power of Preferred Stocks, April 24, 2001)

Continue Reading...