Preferred stock

Definition

Preferred stock is a type of equity security that gives shareholders preferential treatment in receiving dividends and during liquidation events. It combines features of both debt and equity, often paying fixed dividends and having a higher claim on assets than common stock, but typically lacks voting rights. This makes preferred stock an attractive option for investors seeking stable income while taking on less risk than common equity.

5 Must Know Facts For Your Next Test

1. Preferred stockholders generally receive fixed dividends, which means they get paid before common stockholders when dividends are declared.
2. If a company faces financial trouble and must liquidate its assets, preferred shareholders have a higher claim on the company's assets than common shareholders.
3. While preferred stock typically doesn’t grant voting rights, it may have other features like convertibility into common stock or the ability to accumulate unpaid dividends.
4. The dividend rates on preferred stock can be adjustable or fixed, offering different levels of income certainty for investors.
5. Preferred stock can be callable, meaning the issuing company has the right to buy back the shares at a predetermined price after a specific date.

Review Questions

• How does preferred stock differ from common stock in terms of shareholder rights and dividend payments?
  • Preferred stock differs from common stock primarily in its dividend payment structure and shareholder rights. Preferred shareholders receive fixed dividends that are paid out before any dividends are given to common shareholders, providing more income stability. However, preferred shareholders typically do not have voting rights in corporate decisions, unlike common shareholders who have a say in company governance. This trade-off makes preferred stock appealing for those prioritizing dividend income over control.
• Discuss the advantages and disadvantages of investing in preferred stock compared to bonds.
  • Investing in preferred stock offers several advantages over bonds, including the potential for capital appreciation if the company's value increases. Preferred stocks often pay higher dividends than bonds yield, making them attractive for income-focused investors. However, they also come with risks such as less claim on assets during liquidation compared to bonds, which are prioritized during bankruptcy proceedings. Furthermore, while bonds usually have fixed maturity dates, preferred stocks may remain outstanding indefinitely unless called by the issuer.
• Evaluate how the characteristics of preferred stock can impact an investor's portfolio strategy, particularly in volatile markets.
  • The characteristics of preferred stock can significantly impact an investor's portfolio strategy, especially during volatile market conditions. Given their fixed dividend payments and priority over common stock in asset claims, preferred stocks can provide a more stable income stream during economic downturns when equities may suffer losses. This stability can help balance riskier investments in common stocks and other assets. However, investors should be cautious of interest rate changes, as rising rates can decrease the appeal of fixed-rate preferred dividends compared to new offerings. Thus, incorporating preferred stocks requires careful consideration of overall market conditions and interest rate trends.

Related terms

dividends: Payments made by a corporation to its shareholders, usually from profits, which can be issued as cash or additional shares.

common stock: A type of equity security that represents ownership in a corporation, granting shareholders voting rights and a residual claim on assets after debts and preferred shares are paid.

liquidation preference: The order in which different classes of stockholders are paid in the event of a company's liquidation, with preferred stockholders receiving payment before common stockholders.