Preferred

Lesson

Preferred stock is a type of equity security that offers investors a fixed dividend and priority over common stockholders in the event of liquidation. Preferred stockholders typically do not have voting rights but receive preference in dividend payments and asset distribution.

Practice Question #1

Which of the following is a characteristic of preferred stock?

Terms

Preferred Stock:

A type of equity security offering fixed dividends and priority over common stockholders in liquidation.

Cumulative Preferred Stock:

A type of preferred stock that accumulates unpaid dividends, which must be paid before any dividends are paid to common stockholders.

Non-Cumulative Preferred Stock:

A preferred stock that does not accumulate unpaid dividends.

Participating Preferred Stock:

A type of preferred stock that allows stockholders to participate in additional dividends after a certain threshold is met.

Callable Preferred Stock:

The issuer can redeem a preferred stock at a predetermined price.

Practice Question #2

What type of preferred stock accumulates unpaid dividends that must be paid before any dividends are paid to common stockholders?

Do Not Confuse With

Common Stock:

A type of equity security representing ownership in a corporation and typically carrying voting rights.

Practice Question #3

Which type of equity security typically carries voting rights?

Historical Example

In the early 2000s, a large telecommunications company faced financial difficulties and was forced to cut its dividend payments. The company's preferred stockholders continued to receive their fixed dividends, while common stockholders saw their dividends reduced or eliminated.

Real-World Example

A utility company issues preferred stock with a fixed annual dividend of $5 per share. An investor purchases 100 shares of this preferred stock, entitling them to receive $500 in annual dividend payments. If the company were to go bankrupt, the preferred stockholder would have priority over common stockholders in receiving any remaining assets.

Rhyme

Preferred stock is quite unique, fixed dividends and priority it seeks. No voting rights, but assets first, in liquidation, it quenches its thirst.

More Detail

$ *Cumulative preferred stock*: A type of preferred stock that accumulates unpaid dividends, which must be paid out before any dividends can be paid to common stockholders. $ *Non-cumulative preferred stock*: A type of preferred stock that does not accumulate unpaid dividends. If a dividend is skipped, it is not owed to the shareholder later. $ *Cumulative preferred versus non-cumulative preferred*: The main difference between these two types of preferred stock is the treatment of unpaid dividends. Cumulative preferred stockholders can receive any missed dividends, while non-cumulative preferred stockholders do not. $ *Participating preferred stock*: A type of preferred stock that allows the holder to receive additional dividends if the company meets specific financial performance goals or if common stock dividends exceed a specified level.

More Detail Examples

$ *Cumulative preferred stock example*: Company A issues cumulative preferred stock with a 5% dividend rate. If the company skips a dividend payment, the cumulative preferred stockholders are still entitled to receive the missed dividend before any dividends are paid to common stockholders. $ *Non-cumulative preferred stock example*: Company B issues non-cumulative preferred stock with a 5% dividend rate. If the company skips a dividend payment, the non-cumulative preferred stockholders do not have the right to receive the missed dividend. $ *Participating preferred stock example*: Company C issues participating preferred stock with a 5% dividend rate. If the company's profits exceed a certain threshold, participating preferred stockholders may receive additional dividends on top of the regular 5% dividend rate.

Pitfalls to Remember

*Cumulative preferred stock pitfall*:

Investors should be aware that while cumulative preferred stock offers the potential for missed dividends to be paid later, there is no guarantee that the company will have the financial ability to pay those dividends.

*Non-cumulative preferred stock pitfall*:

Investors should understand that non-cumulative preferred stock does not provide the same dividend protection as cumulative preferred stock, and missed dividends will not be paid later.

*Participating preferred stock pitfall*:

The additional dividends offered by participating preferred stock are contingent on the company meeting specific financial performance goals or common stock dividends exceeding a specified level, which may not occur.