Preferred stock is a distinct form of equity ownership in a corporation that combines characteristics of both stocks and bonds. It grants shareholders fixed dividend payments, generally at a predefined rate, with priority over common stockholders for dividend distribution and claims on company assets if the business is liquidated. However, preferred stockholders typically do not have voting rights, distinguishing it from common stock.
Historical Context of Preferred Stock
Preferred stock originated in the 19th century as a financial instrument that allowed companies to raise capital without incurring debt or diluting voting control. It was designed to appeal to investors seeking steady income similar to bonds while retaining some equity ownership benefits.
Over time, several varieties of preferred stock have developed, including cumulative preferred stock, where missed dividends accumulate and must be paid before common dividends, and convertible preferred stock, which can be exchanged for common shares under certain conditions.
How Preferred Stock Functions
When a company issues preferred stock, it agrees to pay dividends at a fixed rate, often expressed as a percentage of the stock’s par value. These dividends are prioritized over common stock dividends, ensuring preferred shareholders receive payments first. For example, if a company issues preferred stock at a 5% dividend rate on a $100 par value share, preferred shareholders expect $5 annually before any dividends to common stockowners.
Key features include:
- Dividend Priority: Preferred shareholders are entitled to dividends before common shareholders. With cumulative preferred stock, unpaid dividends will accumulate and be owed in the future.
- Liquidation Preference: In bankruptcy or liquidation, preferred shareholders have priority over common stockholders to receive company assets after creditors are paid.
- Voting Rights: Generally, preferred stockholders do not have voting rights unless specified, preserving control for common shareholders.
Benefits and Use Cases
Preferred stock offers investors predictable income through fixed dividends, which is particularly attractive for retirees or income-focused portfolios. It provides a middle ground—offering more income stability than common stocks but with more growth potential than bonds.
Companies use preferred stock to raise capital flexibly, avoiding new debt obligations and preserving voting control. This is beneficial for banks, utilities, and startups, especially venture-backed firms issuing preferred shares with special rights like liquidation preferences to protect investors.
Important Considerations for Investors
- Dividend Terms: Understand whether dividends are cumulative or non-cumulative, as missed dividends on non-cumulative preferred shares are not payable later.
- Convertible Features: Convertible preferred stock can be exchanged for common stock, allowing investors to participate in company growth.
- Credit Risk: Preferred dividends are not guaranteed; financial distress can lead to suspension of payments, especially with non-cumulative stock.
- Portfolio Role: Preferred stock balances risk between bonds and common stock, making it suitable for income and diversification.
Common Misunderstandings
- Not Safer Than Bonds: Preferred stock is subordinate to debt holders and usually riskier than bonds.
- No Voting Rights By Default: Most preferred shares do not confer voting privileges.
- Dividends Can Be Skipped: Companies may skip dividends without bankruptcy, particularly for non-cumulative preferred shares.
Frequently Asked Questions
Can preferred stock prices fluctuate?
Yes, preferred stock prices change with interest rates, company performance, and market trends.
Are preferred dividends guaranteed?
No. While preferred dividends have priority, they can be suspended, especially on non-cumulative stocks if the company faces financial hardship.
How does preferred stock differ from common stock?
Preferred stockholders receive dividends first and have priority during liquidation but usually lack voting rights, unlike common stockholders who vote but have lower claims on income and assets.
Comparison Table: Preferred Stock vs. Common Stock
| Feature | Preferred Stock | Common Stock |
|---|---|---|
| Dividend Priority | First and often fixed | Paid after preferred dividends |
| Voting Rights | Typically none | Yes |
| Claim on Assets | Priority over common stock in liquidation | Last in line |
| Price Stability | Generally more stable | More volatile |
| Investment Focus | Income-oriented | Growth and income |
For more details on related topics, see our definitions of Dividend and Common Stock.
References
- Investopedia, Preferred Stock: https://www.investopedia.com/terms/p/preferredstock.asp
- U.S. Securities and Exchange Commission: https://www.investor.gov/introduction-investing/investing-basics/glossary/preferred-stock
- NerdWallet, Preferred Stock Guide: https://www.nerdwallet.com/article/investing/preferred-stock
- IRS Publication on Investment Income: https://www.irs.gov/pub/irs-pdf/p550.pdf
External Resource: For official IRS-related tax information on dividends and stock investments, visit IRS.gov.