InvestorQ : What exactly is preferred stock and how does it add value to issuers and to investors?
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What exactly is preferred stock and how does it add value to issuers and to investors?

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1 year ago

While there may be many kinds of hybrids in the investment universe, preferred stock occupies an important position. You must have heard of the old saying, "Neither fish nor fowl". It is a commonly cited folk saying referring to something that's difficult to define or classify. But amid the typically well-defined boundaries of investment performance, "fish and fowl" may be a more apt description for some securities. While there may be many kinds of hybrids in the investment universe, preferred stock occupies an important position. It has investment performance characteristics that could combine some degree of exposure to both equity and debt of a particular issuer.

What exactly is meant by preferred stock?

Preferred shares are so called because they give their owners a priority claim whenever a company pays dividends or distributes assets to shareholders. They offer no preference, however, in corporate governance, and preferred shareholders frequently have no vote in company elections. The exact terms of preferred shareholders’ economic preference may vary from company to company. In some cases, the preference states simply that cash available for distributions during the year must be used to meet promised payments to preferred shareholders before any common dividends can be paid. In other cases, the preference is applied cumulatively so that any missed payments to preferred shareholders must be made up before common shareholders are allowed to receive anything.

One consequence of the preference system is that preferred shares may provide equity investors with more stable cash flow potential relative to common stock, behaving in this dimension more like an investment in bonds than stock. But unlike bonds, preferred shares carry no general commitment to repay principal. And the market value of preferred shares tends to behave more like common stock, varying in response to the business performance and earnings potential of the issuer.

In addition to these general characteristics, there are many individual considerations when evaluating a preferred stock investment. Many preferred share issues use a percentage in the title. This percentage typically refers to the size of the promised dividend expressed as a portion of the share’s issuance price. A preferred share’s dividend yield is typically its promised (or most recently declared) dividend as a portion of current market value.

Preferred stock dividends are generally not considered automatic entitlements but instead are typically declared individually by the board of directors. Any unpaid preferred dividends would generally rank below obligations to creditors in the event of bankruptcy or liquidation.

One issue is that the companies may issue multiple series of preferred shares, each of which has different economic rights. Frequent distinctions include the relative size of each series’ dividend and the order of preference for payments. Each series must be evaluated individually to understand the value of its dividend promises and the strength of its particular preference. Holders of preferred shares may recover some or all of the issuance value of their shares in the event of the company’s liquidation. Their claims on residual assets would typically rank ahead of common stockholders but behind bondholders and secured creditors.

Preferred shares may come with mandatory or optional features that allow the company to buy shares back at a predetermined price or to convert preferred shares to common shares. Parameters for these call or conversion options should be spelled out in a prospectus or other formal offering document. When considering preferred stock, keep in mind that every issue of this security is an individually customized hybrid with its own unique risk and reward potential. A careful study of specific terms is needed to determine whether the security’s investment profile will fit any particular portfolio objective.