- Preferred stock is a type of share that pays a fixed amount in annual dividends. Unlike bonds, which also tend to have a fixed payout ratio, preferred shares do not expire. These shares are "preferred" in the sense that they must receive all unpaid dividends first before common shareholders can be paid any dividends. As such, preferred shares are considered a safer investment compared to common stock. Although preferred shares do not expire, the issuing firm may decide to "retire" them by purchasing all or nearly all of these shares in the open market. This is usually done when the company has too much cash and wishes to get rid of the annual dividend expense resulting from outstanding preferred shares.
- As mentioned, the dividends due on preferred shares must be paid in full before common shareholders can be paid. As such, these shares are "senior" to common stock. However, all debt issued by the company, as well as money owed to banks, suppliers and employees has priority over preferred shares. In case of bankruptcy, all outstanding debt must be paid in full before preferred shareholders are paid. Common shareholders are last in line. An important difference between dividends on bonds and preferred stock is that, when the firm fails to make payments on bonds, it is in default and creditors can take legal action. Preferred stock dividends, however, can be postponed without such consequences.
- Unlike common stock, preferred shares have no voting rights. Under most circumstances this deficit in legal rights makes little to no difference for small investors. Most smaller buyers of common stock do not exercise their right to vote in the shareholders meetings. When they do, they rarely expect to make a substantial difference. Larger investors, on the other hand, such as mutual funds and insurance firms, may accumulate common shares with the intent of voting out the existing management team. For them, preferred stock is an inferior tool during such battles.
- Dividends on preferred stock are calculated based on the par value of the shares. The prospectus, which is the legal document explaining the rights of stockholders, details the par value as well as dividend rate of the preferred stock. The annual dividend is calculated by multiplying the par value by the dividend rate. A preferred stock with par value of $1,000 and 6 percent annual dividends will pay $60 per year. This sum can be paid once per year, or in two or four installments per year, as declared in the prospectus.
- Although preferred shares are paid before common stock in bad times, they have a more limited appreciation potential. This is because the maximum amount that can be paid to preferred shareholders is the annual dividend. When the firm does exceptionally well, the preferred shares still receive this amount. Common shares, on the other hand, can be paid an infinite sum and have therefore much greater potential to appreciate in good times.
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