11.4 Preferred Stock

Preferred stock is a unique financial instrument that blends characteristics of both stocks and bonds. It offers fixed dividend payments and priority over common stockholders during liquidation, making it an attractive option for income-seeking investors who want a balance of stability and potential growth.

Understanding preferred stock is crucial for grasping the complexities of corporate capital structures. Its features, such as cumulative dividends, callability, and convertibility, provide companies with flexibility in managing their finances while offering investors various ways to participate in a company's success.

Preferred Stock

Key characteristics of preferred stock

• Represents ownership in a company and provides priority over common stockholders during liquidation
• Offers fixed dividend payments (similar to interest on debt) that are paid before any dividends to common stockholders
  • Dividends can be cumulative, requiring unpaid dividends to accumulate and be paid in the future (cumulative preferred stock)
  • Non-cumulative preferred stock does not require unpaid dividends to be paid later
• May be callable or redeemable by the issuing company at a predetermined price after a specified date
• Some preferred stocks can be converted into a specified number of common shares (convertible preferred stock)
• Generally lacks voting rights unless specified or when dividends are in arrears
• Can be perpetual, with no fixed maturity date (perpetual preferred stock)

Intrinsic value calculation for preferred stock

• Intrinsic value of preferred stock calculated using the dividend yield formula: $Intrinsic Value = \frac{Annual Dividend}{Dividend Yield}$
  • Annual Dividend: fixed annual dividend payment per share
  • Dividend Yield: market-determined yield investors require for the given level of risk
• Example: Preferred stock with a $5 annual dividend per share and a required 4% dividend yield
  • Intrinsic Value = \frac{\5}{0.04} = $125$

Preferred stock vs common stock

• Similarities
  • Both represent ownership in a company and have the potential for capital appreciation
  • Traded on stock exchanges
• Differences
  • Dividend payments
    • Preferred stock: fixed dividends paid before common dividends
    • Common stock: variable dividends dependent on company performance and board approval
  • Liquidation preference
    • Preferred stockholders are paid before common stockholders during liquidation
  • Voting rights
    • Common stockholders typically have voting rights
    • Preferred stockholders generally do not, unless specified or when dividends are in arrears
  • Callability and convertibility
    • Some preferred stocks may be callable or convertible
    • Common stocks are typically not callable or convertible

Types of Preferred Stock

• Participating preferred stock: allows holders to receive additional dividends beyond the stated rate if certain conditions are met
• Adjustable-rate preferred stock: dividend rate adjusts periodically based on changes in a specified benchmark interest rate
• Trust preferred securities: hybrid securities that combine features of preferred stock and corporate bonds, often issued by bank holding companies

Investment Options

• Investors can gain exposure to preferred stocks through individual securities or preferred stock ETFs, which offer diversification across multiple preferred stock issues