Preferred stock

Definition

Preferred stock is a type of equity security that provides shareholders with preferential treatment regarding dividend payments and asset liquidation compared to common stockholders. This means that preferred stockholders receive dividends before common stockholders and have a higher claim on assets in the event of liquidation, making it an attractive investment option for those seeking income stability. Preferred stock often comes with fixed dividends, providing a steady return on investment.

5 Must Know Facts For Your Next Test

1. Preferred stock can be convertible, allowing holders to exchange their shares for common stock at predetermined terms, which can increase their upside potential.
2. It usually does not carry voting rights, meaning preferred stockholders do not have a say in corporate governance like common shareholders do.
3. In times of financial distress, companies may choose to suspend preferred dividends without triggering bankruptcy, which can create risk for investors.
4. Preferred stocks can be callable, allowing the issuing company to repurchase shares at a specified price after a certain date, providing flexibility for the issuer.
5. The fixed dividend nature of preferred stocks makes them similar to bonds, making them appealing to conservative investors looking for steady income.

Review Questions

• How does the preferential treatment of preferred stockholders during dividend payments and liquidation affect investor decisions?
  • The preferential treatment of preferred stockholders significantly influences investor decisions by offering a more secure form of investment compared to common stocks. Since preferred stockholders receive dividends before common shareholders and have a higher claim on assets in the event of liquidation, they may appeal more to risk-averse investors. This stability makes preferred stocks attractive for those who prioritize income over voting rights or capital gains.
• Evaluate the impact of callable features in preferred stocks on both investors and companies.
  • The callable feature of preferred stocks allows companies to repurchase shares at predetermined prices after a specific date. For companies, this flexibility can be beneficial during periods of declining interest rates or improved financial conditions, as they can refinance their capital at lower costs. However, for investors, callable shares may limit potential upside if the company buys them back when their market value increases, potentially reducing their long-term investment gains.
• Assess the risks and rewards associated with investing in preferred stock compared to other equity securities.
  • Investing in preferred stock offers a balance of risks and rewards that differs from common stocks and bonds. The key rewards include stable dividend payments and a higher claim during liquidation, appealing to income-focused investors. However, risks include the lack of voting rights and potential suspension of dividends during tough financial periods. Compared to common stocks, preferred stocks present less risk but also limit capital appreciation potential, making them suitable for conservative portfolios while requiring careful consideration against other equity investments.

Related terms

common stock: Common stock represents ownership in a company and typically provides voting rights, but its dividends are paid after preferred stock dividends.

dividend yield: The dividend yield is a financial ratio that indicates how much a company pays out in dividends each year relative to its share price.

liquidation preference: Liquidation preference refers to the order in which investors are paid back in the event of a company's liquidation, with preferred stockholders being paid before common stockholders.