Preferred shares, also known as preference shares or preferred stock, are a type of ownership in a company that combines features of both common stock and bonds. Preferred shares are often issued by companies to raise capital and offer investors a more stable income stream compared to common shares. In this article, we will discuss the features, advantages, and disadvantages of preferred shares along with the comparison with common stocks by giving suitable examples.
First of all, let us have a look at why a company provides preferred stocks.
Reasons why a company might issue preferred stocks
Companies issue preferred stocks as a way to raise capital without diluting the ownership of existing shareholders or incurring too much debt. Unlike common stocks, which represent ownership in the company and have voting rights, preferred stocks represent a claim on a fixed amount of dividends and generally do not have voting rights.
- Attract investors who want a fixed income: As I’ve early explained, Preferred stocks generally pay fixed dividends, which makes them attractive to investors who want a stable income stream. This can be particularly appealing to retirees or other investors who are looking for income-generating investments.
- Meet regulatory requirements: In some industries, such as banking, insurance, and utilities, regulatory bodies require companies to maintain a certain amount of capital in order to ensure their financial stability. Issuing preferred stocks can be a way for companies to raise the necessary capital without taking on too much debt.
- Manage cash flow: Because preferred stock dividends are fixed, companies can use them to manage their cash flow more effectively. This can be particularly useful for companies that have seasonal fluctuations in revenue or need to make large capital expenditures.
- Expand investor base: By issuing preferred stocks, companies can attract investors who might not be interested in common stocks. This can help to broaden the investor base and increase demand for the company’s securities.
- Take advantage of tax benefits: In some cases, preferred stock dividends may be tax-deductible for the company, which can reduce their overall tax burden.
Features of Preferred Shares
Though it belongs to Equity security, preferred shares have the features of both common stocks and bonds(ie: equity and debt securities). This is the reason why it is often called hybrid security.
Here are the important features of preferred stocks:
- Preferred shares usually have a fixed dividend payment, which is paid out before common stock dividends.
- Preferred shares typically do not have voting rights, which means that shareholders do not have a say in the management of the company.
- Preferred shares may have a call provision, which allows the company to redeem the shares at a certain price after a certain date.
- Preferred shares may have a cumulative provision, which means that any missed dividend payments must be paid in full before any dividends are paid to common shareholders.
- Preferred shares may have a conversion provision, which allows shareholders to convert their shares into common stock at a predetermined price.
- Dividends of preferred shares are often based on the par value
If you are willing to invest in preferred stocks it is really important to read and understand the company’s preferred stock prospectus. It defines what kind of preferred stocks are the company providing and their related data. All companies may not provide all the features I’ve pointed out earlier.
What is common stock?
Common stock, also known as ordinary shares, represents ownership in a corporation. It is one of the primary types of stock that a company issues when it goes public. Here are some key points about common stock:
- Ownership: When you own common stock in a company, you become a shareholder and have a proportional ownership stake. The number of shares you hold determines your ownership percentage in the company.
- Voting Rights: Common stockholders typically have the right to vote on certain matters related to the company’s operations. This includes electing the board of directors, approving certain corporate actions, and voting on major decisions that affect the company’s direction.
- Dividends: Common stockholders may be eligible to receive dividends, which are a portion of the company’s profits distributed to shareholders. However, it’s important to note that companies are not obligated to pay dividends, and the decision to distribute them rests with the company’s board of directors.
- Capital Appreciation: Another potential benefit of owning common stock is the opportunity for capital appreciation. If the company’s value increases over time, the price of its common stock may rise, allowing shareholders to sell their shares at a higher price and potentially earn a profit.
- Risk and Residual Claims: Common stockholders bear a level of risk as they are the last in line to receive assets in the event of liquidation or bankruptcy. If a company faces financial difficulties, common stockholders may not receive any proceeds until other obligations, such as debt payments and preferred stockholder claims, have been satisfied.
- Limited Liability: One advantage of owning common stock is that shareholders have limited liability. This means that their personal assets are generally protected, and they are not personally responsible for the company’s debts beyond the amount invested in the shares.
Overall, common stock represents ownership, voting rights, potential dividends, and the opportunity for capital appreciation in a company. However, it also carries risks, and the return on investment is subject to the performance of the company.
Is common stock an asset?
Actually, common stock is considered an asset. An asset is something that has value and can be owned or controlled with the expectation that it will provide future benefits. Common stock represents ownership in a company and entitles shareholders to certain rights, such as voting on corporate matters and receiving dividends. Shareholders can buy and sell common stock on the open market, and the value of the stock may appreciate or depreciate over time. Therefore, common stock is considered an asset in the context of an individual’s investment or portfolio.
What is the difference between common stock and preferred stock?
- Ownership and Voting Rights:
- Common Stock: Common stock represents ownership in a company and typically grants voting rights to shareholders. Each share of common stock generally carries one vote, allowing shareholders to participate in corporate decision-making, such as electing board members or approving major company changes.
- Preferred Stock: Preferred stock also represents ownership, but it may not always include voting rights. In many cases, preferred shareholders do not have voting power or have limited voting rights. They are often excluded from participating in certain company decisions.
- Common Stock: Dividends paid to common stockholders are not fixed and can vary over time. The company’s board of directors determines the distribution of dividends, and if the company faces financial difficulties or chooses not to distribute dividends, common stockholders may not receive any dividends.
- Preferred Stock: Preferred stockholders generally receive fixed dividends on a regular basis. These dividends are often set at a predetermined rate, specified in the stock’s terms. Preferred shareholders are entitled to receive dividends before any dividends are paid to common stockholders.
- Priority in Liquidation:
- Common Stock: In the event of liquidation or bankruptcy, common stockholders have the lowest priority in terms of claiming a company’s assets. They are considered residual claimants, meaning they are paid from the remaining assets after all debts, obligations, and preferred stockholder claims have been settled.
- Preferred Stock: Preferred stockholders have a higher priority than common stockholders when it comes to claiming assets during liquidation or bankruptcy. They have a preferential position and are entitled to receive their investments back or a predetermined liquidation preference before common stockholders receive any remaining assets.
- Capital Appreciation:
- Common Stock: Common stockholders have the potential for capital appreciation as the value of the company increases. If the stock price rises, common stockholders can benefit from selling their shares at a higher price and earning a profit.
- Preferred Stock: Preferred stock generally lacks substantial potential for capital appreciation. Its value is more influenced by other factors such as interest rates and dividend payments rather than overall changes in the company’s value. Preferred stock is often favoured by investors seeking a steady income stream rather than capital gains.
Advantages of Preferred Shares over Common Stocks
- Fixed Dividend: Preferred shares provide a stable income stream for investors because they typically have a fixed dividend payment. In common stocks dividends may not be fixed or stable(remember: a company can stop paying dividends to both common and preferred stockholders. But it’s less likely for the company to do this to preferred holders than common stockholders)
- Seniority: In the event of bankruptcy or liquidation, preferred shareholders have priority over common shareholders in receiving payment.
- Lower Risk: Preferred shares are generally less risky than common shares because of their fixed dividend payment and priority in receiving payment in the event of bankruptcy or liquidation(winding up of the company). if you want to go less risky in the market, preferred stocks are preferred over common stocks
- Tax Benefits: In some jurisdictions, preferred share dividends may be taxed at a lower rate than common share dividends. In the United States, for example, corporations may be able to deduct up to 50% of the dividends paid on preferred stocks from their taxable income, under certain conditions. This tax deduction is known as the “dividends received deduction” and can help companies to reduce their overall tax burden. The tax treatment of preferred stock dividends is generally the same as for common stock dividends. Preferred stock dividends are considered “qualified dividends” if they meet certain criteria, such as being paid by a U.S. corporation or a foreign corporation with shares that are readily tradable on a U.S. exchange, and the investor holding the stock for a certain period of time. Qualified dividends are taxed at a lower rate than ordinary income, which can provide a tax benefit for investors. For individual investors, the tax depends on the country as well as the investor’s personal tax situation. It’s important to note that tax laws are subject to change and can be complex, so investors should consult with a qualified tax professional before making any investment decisions based on tax considerations.
- Convertibility: Preferred shares, as I explained early, can be converted to common stocks when we like. But common stocks can be converted to preferred stocks.
- Higher yield: Typically, the dividends paid by preferred shares generate higher yields than the common stock and investment-grade corporate bonds
- Lower investment per share: Provides higher fixed-income payment with a lower investment per share.
Risks of Preferred Shares
- Limited Growth Potential: Preferred shareholders do not have voting rights, which means that they do not have a say in the management of the company and cannot benefit from potential growth opportunities. (if you are not interested in voting and other rights on the company, it’s good to go with preferred stocks)
- Interest Rate Risk: Preferred shares are similar to bonds in that their value is affected by changes in interest rates. ie: Preferred stocks are sensitive to changes in interest rates, which can affect their market value. If interest rates rise, the value of preferred shares may decline.
- Inflation Risk: Because preferred shares have a fixed dividend payment, their value may decline in real terms if inflation rises.
- Call Risk: If a company has a call provision, they may choose to redeem the preferred shares at a certain price, which may be lower than the market value of the shares. This can be disadvantageous for investors if interest rates have fallen since the preferred stock was issued.
- Credit risk: Preferred stocks are issued by companies, and like any other investment in a company, they are subject to credit risk. If the issuing company runs into financial difficulties or defaults on its obligations, investors may not receive the full value of their investment.
- Liquidity risk: Preferred stocks can be less liquid than other types of investments, such as common stocks or bonds. This means that it may be difficult to sell the shares at a fair price, especially in a market downturn.
- Conversion risk: Convertible preferred stocks can be converted into common stock at a predetermined price and ratio. If the price of the common stock falls, the value of the convertible preferred stock may also fall.
- Market risk: Preferred stocks are traded on the open market and are subject to market volatility, which can affect their price and yield.
Overall, preferred shares offer a stable income stream and priority in receiving payment in the event of bankruptcy or liquidation. However, they also have limited growth potential and are subject to interest rates and inflation risks. Before investing in preferred shares, it is important to consider your investment objectives, risk tolerance, and overall portfolio diversification.
Preferred stocks are of many kinds. Understanding all of them is equally important to have wise investments.
Most common types of preferred stocks:
- Cumulative preferred stock: This type of preferred stock entitles the holder to receive dividends that have been missed in the past, in addition to the current dividend. In other words, if the company misses a dividend payment one year, it will owe the holder of cumulative preferred stock that payment in the future, along with the regular dividends.
- Non-cumulative preferred stock: This type of preferred stock does not have the feature of cumulative dividends. If the company misses a dividend payment one year, it does not owe the holder of non-cumulative preferred stock that payment in the future.
- Convertible preferred stock: This type of preferred stock can be converted into a predetermined number of common shares of the same company. The conversion ratio is usually stated in the preferred stock prospectus.
- Callable preferred stock: This type of preferred stock can be redeemed by the company at a certain price and time, usually after a specified period of time has elapsed. This gives the company more flexibility in managing its capital structure.
- Adjustable-rate preferred stock: This type of preferred stock has a dividend rate that is adjustable based on a predetermined benchmark rate, such as the prime rate or Treasury rate.
- Participating preferred stock: This type of preferred stock entitles the holder to receive additional dividends beyond the stated rate if the company has a particularly profitable year. The amount of additional dividends is usually stated in the preferred stock prospectus.
- Perpetual preferred stock: This type of preferred stock has no maturity date and pays dividends indefinitely unless the company redeems the stock
Now let me give you a clear idea by giving real-world examples.
Disclaimer: We have randomly selected a company for illustration. We have not to do anything with this company or its stocks. The data are used for educational purposes only.
I am choosing a preferred stock provider in the US market. let’s say Wells Fargo & Co. (WFC), is a diversified financial service holding company. Let’s take WFC-PR into consideration, one of the preferred stocks provided by the company.
Here is the comparison chart between the price of WFC and WFC-PR
The blue line represents WFC (common stock) and the green line represents WFC-PR (preferred stock)
This is a one-year chart(2022 APR – 2023 APR). Here from this table itself, it becomes clear that the value of preferred stock is different (lower) than the common stock value.
We see that it is almost stable while the common stock value went through numerous ups and downs. This image is a proof for the fact that we can’t assume huge capital appreciation (or growth of the invested money) from preferred investment.
What about dividends? let’s check it out:
The historical dividend chart of preferred stock seems almost stable while common stock seems to vary. At the time of 2020-2021, the common stock dividend shoot down to $ 0.1 per share(approximately). But the company still paid a stable dividend to its preferred shareholders.
Now, let us assume that we had 200000 USD in hand in the year 2014 for investing in the stock market. We chose WFC (common stock) and WFC-PR (preferred stock) to invest in. So we split our entire 200K dollars into two and put each 100K dollars for buying WFC stock at $45.340 per share and WFC-PR at $26.310 per share (the closing price on 1st January 2014 of both the stocks).
So as per calculation,
Number of WFC stocks bought = 100000/45.340 = 2205 stocks
This means the total investment here in WFC is $99974.7 (ie 2205*45.340)
number of WFC-PR stocks bought = 100000/26.310 = 3800 stocks
This means the total investment here in WFC-PR is $99978 (ie 3800×26.310)
Time went by and we found 1st January 2023 the time to sell all the stocks. For almost 9 years we took possession of our WFC and WFC-PR stocks and this is the time to account for the capital appreciation.
WFC is now (1 Jan 2023) at a value of $46.870
capital appreciation of a share = $46.870 – $45.340 = $1.530
So in the form of Capital appreciation, WFC gave you a profit of 1.530 * 2205 = $3373.65
Always remember this fact: dividend stocks will not show dramatic growth (capital appreciation) to your money as other stocks. the companies that have covered their growth phase generally pay dividends as they need not use all their profit for further research and other activities like the growing companies do. This is why we say dividend investors are those people whose aim is to create frequent income from the stock market rather than good returns. we have created a dedicated post on the topic “Is dividend investing a good strategy“. click here to go quickly to the article.
Now let’s consider the dividends of WFC stock.
Here’s the table showing the dividend payout history of WFC from the time we are eligible for getting dividends to the time we got the last dividend.
We can see here that the common stock’s dividend is not the same year. It fluctuates according to corporate conditions. As we bought the stock on 01/01/2014, we are eligible to get the first dividend on 03/01/2014 (because the ex-dividend date, as you can see, is after when we bought the stock).
The following table will give you the data on the total amount we could able to acquire collectively from all the dividend payouts.
Oh great, we got an overall amount of $27253.8 from dividends only. this is way more than the capital appreciation we got.
So as a sum total (from dividend and return), we got a profit of $27253.8 + $3373.65 = $30627.45
It’s time to pay attention to WFC-PR stock (the preferred stock). We know that the price value of preferred stocks is based on the par value and it doesn’t show as many dramatic fluctuations in the graph as the common stocks do. from the chart I’ve given earlier, it’s crystally clear. look
On 1 Jan 2023, the day we sell the common stock / called up the preferred stock, WFC-PR is at a value of $25.260
Then the capital appreciation per share becomes 25.260 – 26.310 = – $1.050
This is a loss. This would cause us to feel the pain of the overall loss of 1.050 * 3800 = $3990. The loss seems to be greater than the profit we booked from the common stock.
Time for the dividend analysis(the true power of preferred stocks). Here’s the table which shows the WFC-PR dividend payout data:
The table shows the dividend history of the WFC-PR stock on our eligible time interval. The dividend amount is the same (fixed) all over the time (except the first time) even at the time when the company is forced to reduce the dividend amount of the common stockholders, they hooked with the fixed dividend for preferred shareholders.
On calculating the average dividend paid by the common stock, we get it to be lesser than the fixed amount of 0.4141 USD given by the preferred stock.
Let us now calculate the overall income we got through dividends.
Whoa! It’s an incredible profit when compared to the common stock’s (WFC) overall dividend income.
From the common stock’s dividends, it was just only $27253.8. Here from the preferred stock, we got $56596.44 which is $29342.64 more (more than double!).
So the overall profit on investing in the preferred stock (WFC-PR) is $56596.44 – $3990 = $52606.44
|NO. OF YEARS
|NUMBER OF STOCKS
|– $3990 (LOSS)
What we got from this entire example is that the overall profit we got from the preferred stock is way greater than the common stock though we faced a loss in the return (capital appreciation). This is just the case of the American financial company Wells Fargo & Co. We can’t assume the same on all the stocks but most generally yeah. There may be companies there that show a profit in return on preferreds and likewise gives almost constant dividends for common stockholders too.
But what made this large difference in the overall profit is not mostly because of dividends or capital growth. But it’s the very fact that we can buy more preferred stocks than common stocks with the same amount as preferred stocks are based upon the company’s par value. Not the higher market value.
When the company’s board of directors thinks to give let’s say 0.5 dollars per share for both the common and preferred holders, our preferred stock gives us more income as there are more stocks.
Let me illustrate the fact: we have an overall 2205 stocks and 3800 stocks respectively as common and preferred. We needed to spend almost the same money to buy these stocks. As the company gives $0.5 per share to both the categories, we get 2205×0.5 = $1102.5 from common stock and 3800×0.5 = $1900 from preferred stock. This accounts mostly for our greater profit in preferred stock investing.
Now you most probably may be asking what if the growth of the common stock was so great that the capital appreciation was greater than the overall dividend amount?
Wonderful question. We all know that the preferred stock will not show a greater return (capital appreciation) than the common stock. It is evident from the chart itself that the fluctuations are really low in the preferreds’ chart on comparison. But you are forgetting the reality that Dividend stocks(dividend-providing stocks) will not show greater returns as the other stocks do. Still confused? Go check this post out
Also, small fluctuations can give us good returns in preferred stocks because we have more shares than we could have been able to buy at common stock with the same money.
So, you have now understood the features, advantages, and disadvantages of investing in preferred stocks. We have familiarised ourselves with the differences between common stocks and preferreds(short form of preference shares). If you want to generate frequent and stable income from the market along with low risk, preference stocks can really help you. If you want greater capital appreciation for your money invested, you need to go with common stocks rather than preferred ones. But remember the fact that diversification in investing is heavily prescribed by intelligent investors. Investing in different-different schemes and securities is a trait of good financial intelligence.