Preferred stock

Definition

Preferred stock is a type of equity security that gives shareholders a higher claim on assets and earnings than common stockholders. It typically pays fixed dividends and has priority over common stock in the event of liquidation, making it an attractive option for investors seeking steady income with less risk compared to common shares.

5 Must Know Facts For Your Next Test

1. Preferred stock often has a fixed dividend rate, which means investors can expect regular income payments.
2. In the case of bankruptcy or liquidation, preferred stockholders have a claim on the company's assets before common stockholders.
3. Preferred shares usually do not have voting rights, which distinguishes them from common stockholders.
4. Some preferred stocks are callable, meaning the issuing company can repurchase them at a set price after a certain date.
5. The market value of preferred stock can fluctuate based on interest rates; when rates rise, preferred stock prices typically fall.

Review Questions

• How does preferred stock differ from common stock in terms of dividends and claims on assets?
  • Preferred stock differs from common stock primarily in its dividend structure and claims on assets. Preferred shareholders receive fixed dividends that are prioritized over dividends paid to common shareholders. In the event of liquidation, preferred stockholders have a higher claim on company assets compared to common stockholders, who only receive payment after all obligations to creditors and preferred shareholders are satisfied.
• Discuss the advantages and disadvantages of investing in preferred stock compared to common stock.
  • Investing in preferred stock has both advantages and disadvantages. On the positive side, preferred stock offers more stable dividend payments and priority in asset claims during liquidation, making it less risky than common stock. However, the downsides include typically no voting rights and limited potential for capital appreciation since their prices are less volatile compared to common stocks. Additionally, the fixed nature of dividends means investors may miss out on higher returns if the company performs exceptionally well.
• Evaluate how changes in interest rates affect the market value of preferred stocks and investor decision-making.
  • Changes in interest rates have a significant impact on the market value of preferred stocks. When interest rates rise, new bonds and other fixed-income securities offer higher returns, making existing preferred stocks with lower fixed dividends less attractive. This often leads to a decline in their market prices. Investors must consider these dynamics when deciding on investment strategies, as rising rates can erode the value of their preferred shares while also influencing their desire for income-generating investments.

Related terms

dividends: Payments made by a corporation to its shareholders, typically out of its profits, which can be issued in cash or additional shares.

liquidation preference: The order in which a company's assets are distributed to shareholders during the liquidation process, where preferred stockholders are paid before common stockholders.

convertible preferred stock: A type of preferred stock that can be converted into a predetermined number of common shares, offering potential for capital appreciation.