Definition / Meaning of Preferred stock
Preferred stock is a unique type of ownership in a company that sits in between common stock and bonds. Think of it as a hybrid security. It gives you ownership in the company, but with different rules compared to regular common stock. The most important difference is that preferred stockholders get paid dividends before common stockholders do. If a company has to cut its dividend, it will cut the common stock dividend first. This makes preferred stock less risky than common stock, but it also usually means less potential for huge price gains.
Preferred stock is called “preferred” because it has a higher claim on the company’s assets and earnings than common stock. For example, if a company goes bankrupt, preferred shareholders are paid before common shareholders. But they are still behind bondholders and other creditors. This makes preferred stock safer than common stock but riskier than a bond.
Key Features of Preferred Stock
Fixed Dividend
Most preferred stocks pay a fixed dividend, much like a bond pays interest. The dividend is usually stated as a percentage of the stock’s par value. For example, a $25 par value preferred stock with a 6% dividend pays $1.50 per share each year ($25 x 0.06 = $1.50). This dividend is typically paid quarterly. Because the dividend is fixed, the price of preferred stock tends to be more stable than common stock, moving up and down based on interest rate changes.
Cumulative vs. Non-Cumulative
- Cumulative preferred stock is the most common type. If the company misses a dividend payment, it must make it up later before it can pay dividends to common stockholders. These unpaid dividends are called “dividends in arrears.” This feature makes cumulative preferred stock safer for investors.
- Non-cumulative preferred stock means that if the company skips a dividend, it does not have to pay it later. The missed dividend is gone forever. This type is riskier and less common.
Par Value
Preferred stock has a par value, which is a set dollar amount determined by the company. The par value is used to calculate the dividend and is also the price at which the company can buy back the stock. Par value is typically $25 or $100. Unlike common stock, which often has a very small par value (like $0.01), the par value of preferred stock matters a lot. When the market price of a preferred stock is at or near its par value, it is considered to be trading normally.
Callable Feature
Many preferred stocks are callable. This means the company can buy back the shares from investors at a set price, usually the par value, after a certain date. Companies do this when interest rates fall. They can call in their old high-dividend preferred stock and issue new shares with a lower dividend. This limits the upside for investors, because if rates drop and the stock price rises above par, the company may call it away.
Convertible Feature
Some preferred stocks are convertible. This means the owner can exchange each preferred share for a set number of common shares. This gives the investor a chance to benefit if the common stock price goes up a lot. Convertible preferred stock usually pays a lower dividend than non-convertible preferred stock because of this extra potential growth.
How Preferred Stock Differs from Common Stock and Bonds
| Feature | Preferred Stock | Common Stock | Bond |
|---|---|---|---|
| Ownership | Yes, but limited rights | Yes, full ownership | No, you are a lender |
| Voting Rights | Usually none | Yes, one vote per share | None |
| Dividend / Interest | Fixed dividend | Variable dividend | Fixed interest payment |
| Payment Priority | After bonds, before common stock | Last to be paid | Paid first |
| Price Stability | Moderate (rates sensitive) | More volatile | More stable |
| Maturity Date | Usually no maturity | No maturity | Fixed maturity |
Liquidity and Market
Preferred stock is not as widely traded as common stock. Most preferred stocks trade on major exchanges like the NYSE or Nasdaq, but the volume is lower. This means that buying or selling a large amount can sometimes affect the price. Many preferred stocks are issued by banks, utilities, and real estate investment trusts (REITs) because these companies often need steady capital and want to offer a stable dividend to attract income-focused investors.
Because preferred stock offers a predictable income stream, it is popular among investors who want steady cash flow, such as retirees. However, because it has limited upside potential and can be called away, it is not suitable for growth investors. Understanding these features helps investors decide if preferred stock fits their portfolio.