Preferred Stock

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Preferred Stock

The term "stock" refers to ownership or equity in a firm. There are two types of equity common stock and preferred stock. Preferred stockholders have a higher claim to dividends or asset distribution than common stockholders. The details of each preferred stock depend on the issue.

Preferred stock gives its holders certain privileges that make them senior to common stockholders. Preferred stockholders are promised a fixed periodic dividend, which is stated either as a percentage or as a dollar amount. 

How the dividend is specified depends on whether the preferred stock has a par value, which, as in common stock, is a relatively useless stated value established for legal purposes.

Par-value preferred stock has a stated face value, and its annual dividend is specified as a percentage of this value.

No-par preferred stock has no stated face value, but its annual dividend is stated in dollars.

Basic Rights of Preferred Stockholders:

The basic rights of preferred stockholders are somewhat more favorable than the rights of common stockholders. Preferred stock is often considered quasi-debt because, much like interest on debt, it specifies a fixed periodic payment (dividend). Of course, as ownership, preferred stock is unlike debt in that it has no maturity date. Because they have a fixed claim on the firm’s income that takes precedence over the claim of common stockholders, preferred stockholders are exposed to less risk. They are consequently not normally given a voting right.

Preferred stockholders have preference over common stockholders in the distribution of earnings. If the stated preferred stock dividend is “passed” (not paid) by the board of directors, the payment of dividends to common stockholders is prohibited. It is this preference in dividend distribution that makes common stockholders the true risk takers.

Preferred stockholders are also usually given preference over common stockholders in the liquidation of assets in a legally bankrupt firm, although they must “stand in line” behind creditors. The amount of the claim of preferred stockholders in liquidation is normally equal to the par or stated value of the preferred stock.

Characteristics of Preferred Stock

Like common stock, preferred stock offers partial ownership in a corporation. Preferred stocks may be participating or non-participating, convertible or non-convertible, cumulative or non-cumulative, redeemable or non-redeemable, or a combination of these features.

Following are some of the main characteristics of preferred stock:

1) Preferred stock has a fixed rate of dividend, which is specified as a percentage of the par value. Also, preference dividends must be paid before ordinary dividends.

2) This type of stock does not allot voting rights to the stockholders.

3) Most preferred stocks are cumulative. If the company fails to pay dividends due each year, the unpaid dividends will be accumulated and shall be paid in a future period.

4) Preferred stocks are less risky than common stocks. In case of bankruptcy or liquidation, the preferred stockholders are paid before the common stockholders.

5) Some preferred stocks are convertible giving the holder the option to convert the shares into a certain number of common stocks on a specific date.

6) Some preferred stocks are redeemable giving the company the right to buy back them at an agreed time and price.

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