Preferred stock is an equity security that has a preference, or senior claim, to the firm’s earnings and assets over common stock. Preferred shareholders must receive their fixed dividend before common shareholders can receive a dividend.
In liquidation, the claims of the preferred shareholders are to be satisfied before common shareholders receive any proceeds. In contrast with common stock, preferred stock generally carries a stated fixed dividend.
The dividend is specified as a percentage of par value or as a fixed number of dollars per year. For example, a preferred stock may be a 9 percent preferred, meaning that its annual dividend is 9 percent of its par or stated value. In such cases, unlike common stock, a preferred stock’s par value does have important meaning, much like par value for a bond.
The dividend for no-par preferred stock is stated in terms of a dollar amount, for example preferred as to dividends in the amount of $9 annually. The holder of preferred stock accepts the limitation on the amount of dividends as a fair exchange for the priority held in the earnings and assets of the company.
Thus, unlike with common stock, the par value of preferred stock is important. Dividends often are expressed as a percentage of par, and the par value represents the holder’s claim on corporate assets in case of liquidation. Additionally, when shares of preferred stock are first issued, the initial selling price is frequently close to the share’s par value.
Because preferred stocks are frequently nonvoting, many corporations issue them as a means of obtaining equity capital without diluting the control of the current stockholders. Unlike coupon interest on bonds, the fixed preferred stock dividend is not a tax-deductible expense.
A major source of preferred stock issues is regulated public utilities, such as gas and electric companies. For regulated firms, the non-deductibility of dividends is not as much of a concern as for other firms because the utilities’ tax payments affect the rates they are allowed to charge.
For foreign firms to issue preferred stock, they must do so in the United States.
The U.S. security markets are the only public financial markets in which preferred stock is sold.
Preferred stock may have special features. For example, it may be cumulative or noncumulative.
Cumulative preferred stock requires that before dividends on common stock are paid, preferred dividends must be paid for the current period and for all previous periods in which preferred dividends were missed.
Unlike debt holders, the preferred stockholders cannot force the payment of their dividends. They may have to wait until earnings are adequate to pay dividends. The cumulative preferred stock offers some protection for periods during which dividends are not declared.
Callable preferred stock gives the corporation the right to retire the preferred stock at its option. Convertible preferred stock has a special provision that makes it possible to convert it to common stock of the corporation, generally at the stockholder’s option.
This, like many of the special features that preferred stock may have, exists primarily to attract investors to buy securities at times when distribution would otherwise be difficult. Preferred stock that is cumulative and convertible is a popular financing choice for investors purchasing shares of stock in small firms with high growth potential.
Participating preferred stock allows preferred shareholders to participate with common shareholders when larger dividend payouts are available.
Holders get a larger dividend, if sufficient earnings exist and if common shareholders will be getting a dividend larger than the preferred shareholders. It is a rarely used feature except in some private equity and venture capital investments.
The one tax advantage of preferred stock goes to corporate investors who purchase another firm’s preferred. When one corporation buys stock of another firm, 70 percent of the dividend income received by the corporation is exempt from taxes. Thus, for every $100 of dividend income, only $30 is taxable to an investing corporation.