Preferred Stock Definition
Preferred stock is a type of stock that usually pays a fixed dividend prior to any distributions to the holders of the common stock of the business. This payment is typically cumulative, so any delayed prior payments must be paid to the preferred stockholders before distributions can be made to the holders of common stock. However, the holders of preferred stock usually gain this advantage in exchange for giving up their right to share in any additional earnings generated by the company, which limits the amount by which the shares can change in value over time.
Preferred Stock Characteristics
In the event of liquidation, the holders of preferred stock must be paid off before common stock holders, but after secured debt holders. Preferred stock holders can have a broad range of voting rights, ranging from none to having control over the eventual disposition of the entity.
Preferred stock dividends may be stated as a fixed amount (such as $5) or as a percentage of the stated price of the preferred stock. For example, a 10% dividend on $80 preferred stock is an $8 dividend. However, if the preferred stock trades on the open market, then the market price will fluctuate in order to achieve a different dividend percentage. For example, the investment community believes that a 10% dividend on a stated share price of $80 is higher than the market rate, so it bids up the price of the stock, so that an investor pays $100 per share. This means that the actual dividend on the preferred stock is still $8, but it has now declined to 8% of the amount paid by the investor. Conversely, if the investment community believes that the dividend is too low, then it bids down the price of the preferred stock, thereby effectively increasing the rate of return for new investors.
Preferred Stock Features
Unlike common stock, there are a variety of features that can be added to preferred stock in order to either increase its attractiveness to investors, or to make it easier for the issuing company to buy back. You may elect to use just one of the following features, or several at once in order to achieve the company's goals and meet the needs of investors:
- Callable. This feature gives a company the ability to buy back preferred stock on specific dates and at predetermined prices. This feature is useful for those companies anticipating that they can secure lower-interest financing elsewhere in the near future. It is opposed by the buyers of preferred stock, who do not want to sell back their shares and then have to presumably use the funds to obtain lower-return investments elsewhere.
- Convertible. This feature gives investors the option to convert their preferred stock into a predetermined number of shares of the company's common stock at some point in the future. The conversion feature is initially set at a conversion ratio that is not attractive to investors at the point of purchase. However, if the price of the common stock increases, then investors can convert to common stock, and may then sell the stock to realize an immediate gain. For example, an investor pays $100 for a share of preferred stock that converts to four shares of the company's common stock. The common stock initials sells for $25 per share, so an investor would earn no profit by converting. However, it later increases to $35 per share, so an investor would be inclined to convert to common stock and sell his four shares of common stock for a total of $140, thereby reaping a profit of $40 per share of preferred stock purchased. This is considered a valuable feature if there is an expectation that a company's value will increase over time.
- Cumulative. If the company is unable to pay dividends to its preferred shareholders, then these dividends are said to be "in arrears," and the cumulative feature forces the company to pay them the full amount of all unpaid dividends before it can pay dividends to its common shareholders. This is a common feature of preferred stock.
- Participative. Investors may want the ability to participate in whatever additional company earnings are left after their preferred dividends have been paid. This feature can cut deeply into the earnings available to common stockholders, and so is opposed by them. The participative feature is usually only granted by companies that have no other means of raising capital.
Of the preferred stock features noted here, the callable feature is less attractive to investors, and so tends to reduce the price they will pay for preferred stock. All of the other features are more attractive to investors, and so tends to increase the price they will pay for the stock.
There is no "boilerplate" type of preferred stock. Instead, companies tend to configure the features associated with their preferred stock offerings to meet the requirements stated by prospective investors. In many cases, attaining a certain price point for the sale of preferred stock will require that the offering include certain features. Without those features, a company may find that it must sell at a lower price per share, or is unable to sell the shares at all.
Preferred Stock Example
Davidson Motors sells 10,000 shares of its Series A preferred stock, which has a par value of $100 and pays a 7% dividend. The investment community believes that the interest rate is somewhat above the current market rate on similar investments, so it bids the price of the stock up to $105 per share. Davidson Motors records the share issuance with the following entry:
|Series A preferred stock ($100 par value)||1,000,000|
|Paid-in capital in excess of par value||50,000|