A Dividend Preference For Preferred Stock Means That

A dividend preference for preferred stock means that preferred stockholders must receive their dividends before common stockholders are paid. This prioritization is a key feature that makes preferred stock attractive to certain investors, offering a degree of income certainty not found in common stock. Understanding this preference, along with other characteristics of preferred stock, is crucial for investors looking to diversify their portfolios and potentially mitigate risk.

Understanding Preferred Stock

Preferred stock is a class of stock that has characteristics of both debt and equity. It offers a fixed dividend, similar to a bond, but represents ownership in a company, like common stock. However, unlike common stock, preferred stock typically does not come with voting rights. The "preferred" in preferred stock refers to the preferential treatment its holders receive compared to common stockholders, most notably regarding dividends and assets in the event of liquidation.

Key Characteristics of Preferred Stock:

Fixed Dividend: Preferred stockholders receive a fixed dividend payment, usually expressed as a percentage of the par value of the stock. This fixed income stream is a primary draw for income-seeking investors.
Dividend Preference: As the title suggests, preferred stockholders have the right to receive dividends before any dividends are paid to common stockholders.
Liquidation Preference: In the event of a company's liquidation, preferred stockholders have a higher claim on assets than common stockholders, though they rank below creditors and bondholders.
No Voting Rights (Typically): Most preferred stock issues do not grant voting rights to holders, limiting their influence on corporate governance.
Callable and Convertible Features: Some preferred stocks are callable, meaning the company can repurchase the shares at a predetermined price. Others are convertible, allowing the holder to exchange their preferred shares for a predetermined number of common shares.

The Dividend Preference in Detail

The dividend preference is arguably the most significant feature of preferred stock. It ensures that the company must fulfill its dividend obligations to preferred stockholders before distributing any profits to common stockholders. This reduces the risk for preferred stockholders and provides a more predictable income stream.

How the Dividend Preference Works:

Dividend Declaration: The company's board of directors must declare a dividend before any payments are made to stockholders. The board assesses the company's financial condition and determines if it can afford to pay dividends.
Preferred Dividend Payment: If a dividend is declared, preferred stockholders are paid their fixed dividend amount first. This payment is mandatory before any dividends can be allocated to common stockholders.
Common Dividend Payment (If Funds Remain): Only after all preferred dividends have been paid can the board consider paying dividends to common stockholders. The amount of the common dividend is at the discretion of the board and can vary depending on the company's performance and financial strategy.

Consequences of Not Paying Preferred Dividends:

No Common Dividends: If a company cannot afford to pay the full preferred dividend, it cannot pay any dividends to common stockholders. This creates a strong incentive for companies to prioritize preferred dividend payments.
Cumulative vs. Non-Cumulative Dividends: The type of preferred stock determines what happens to unpaid dividends.
- Cumulative Preferred Stock: With cumulative preferred stock, any unpaid dividends accumulate and must be paid in full before common stockholders receive any dividends. These accumulated unpaid dividends are known as dividends in arrears.
- Non-Cumulative Preferred Stock: With non-cumulative preferred stock, the holder loses the right to receive any unpaid dividends from prior periods. If the company misses a dividend payment, it is simply forfeited. Non-cumulative preferred stock is riskier for investors but may offer a higher dividend rate to compensate for the added risk.
Potential Impact on Company Reputation: Failing to pay preferred dividends can negatively impact a company's reputation and credit rating. It signals financial distress and may make it more difficult for the company to raise capital in the future.

Advantages and Disadvantages of Dividend Preference

The dividend preference offers several advantages and disadvantages for both investors and the issuing company.

Advantages for Investors:

Income Certainty: The dividend preference provides a higher degree of income certainty compared to common stock. Investors can rely on a fixed income stream as long as the company is financially stable enough to pay dividends.
Reduced Risk: The priority in dividend payments and asset liquidation reduces the risk associated with preferred stock compared to common stock.
Potential for Higher Yields: Preferred stock often offers higher dividend yields than bonds or other fixed-income investments.
Diversification: Preferred stock can be a valuable tool for diversifying an investment portfolio, offering a different risk-reward profile than common stock or bonds.

Disadvantages for Investors:

Limited Upside Potential: Unlike common stock, preferred stock typically does not appreciate significantly in value. The primary return comes from the fixed dividend payments.
No Voting Rights (Typically): The lack of voting rights limits the investor's ability to influence company decisions.
Interest Rate Risk: Preferred stock prices can be sensitive to changes in interest rates. When interest rates rise, the value of preferred stock may decline, and vice versa.
Call Risk: If the preferred stock is callable, the company may redeem the shares when interest rates fall, forcing the investor to reinvest at a lower yield.
Inflation Risk: The fixed dividend payments may not keep pace with inflation, reducing the real return over time.

Advantages for Issuing Companies:

Attracting Investors: Preferred stock can attract investors seeking income and stability, allowing the company to raise capital without diluting the ownership stake of common stockholders.
Flexible Financing: Preferred stock offers a flexible financing option with terms that can be tailored to meet the company's specific needs.
No Mandatory Repayment: Unlike debt, preferred stock does not require mandatory repayment of principal.
Strengthening the Balance Sheet: Preferred stock is classified as equity on the balance sheet, which can improve the company's debt-to-equity ratio and financial standing.

Disadvantages for Issuing Companies:

Higher Cost of Capital: Preferred stock dividends are typically higher than interest payments on debt, resulting in a higher cost of capital for the company.
Dividend Obligations: The company is obligated to pay preferred dividends before common dividends, which can strain the company's finances during periods of low profitability.
Complexity: Preferred stock can be complex to structure and issue, requiring specialized legal and financial expertise.
Potential Dilution (If Convertible): If the preferred stock is convertible, it can lead to dilution of common stock ownership if holders choose to convert their shares.

Factors Affecting Preferred Stock Prices

Several factors can influence the price of preferred stock, including:

Interest Rates: As mentioned earlier, preferred stock prices are inversely related to interest rates. When interest rates rise, the value of preferred stock tends to fall, and vice versa. This is because investors demand a higher yield to compensate for the increased risk of holding fixed-income securities when interest rates are rising.
Company Creditworthiness: The financial health and credit rating of the issuing company significantly impact the perceived risk of the preferred stock. A company with a strong credit rating is more likely to meet its dividend obligations, making its preferred stock more attractive to investors and driving up its price.
Dividend Rate: The dividend rate of the preferred stock is a key determinant of its value. Higher dividend rates generally lead to higher prices, as investors are willing to pay more for a security that provides a greater income stream.
Call Provisions: The presence of call provisions can negatively impact preferred stock prices. Investors may be less willing to pay a premium for callable preferred stock, as the company can redeem the shares when interest rates fall, depriving them of future income.
Market Conditions: Overall market conditions and investor sentiment can also influence preferred stock prices. During periods of economic uncertainty or market volatility, investors may flock to safer assets like preferred stock, driving up demand and prices.

Types of Preferred Stock

Besides cumulative and non-cumulative preferred stock, there are other variations to consider:

Convertible Preferred Stock: Allows the holder to convert their preferred shares into a predetermined number of common shares. This feature provides the potential for capital appreciation if the company's stock price rises.
Callable Preferred Stock: Gives the issuing company the right to repurchase the shares at a specified price, typically after a certain date. This feature allows the company to refinance its capital structure if interest rates fall.
Participating Preferred Stock: Entitles the holder to receive additional dividends beyond the fixed rate if the company's profits exceed a certain level. This feature provides the potential for higher returns if the company performs well.
Adjustable-Rate Preferred Stock: Pays a dividend that is tied to a benchmark interest rate, such as LIBOR or the prime rate. This feature helps to protect investors against rising interest rates.

Who Invests in Preferred Stock?

Preferred stock is often favored by:

Income-Seeking Investors: Retirees, pension funds, and other investors who rely on a steady stream of income may find preferred stock attractive.
Corporate Investors: Corporations may invest in preferred stock to take advantage of the dividends received deduction (DRD), which allows them to deduct a portion of the dividends they receive from other corporations.
Conservative Investors: Investors who are risk-averse and seeking a more stable investment than common stock may find preferred stock appealing.

How to Evaluate Preferred Stock

Before investing in preferred stock, it's essential to conduct thorough research and consider the following factors:

Company Financials: Analyze the company's financial statements to assess its ability to pay dividends. Look for consistent profitability, strong cash flow, and a healthy balance sheet.
Credit Rating: Check the credit rating of the preferred stock and the issuing company. A higher credit rating indicates a lower risk of default.
Dividend Yield: Compare the dividend yield of the preferred stock to other similar investments. A higher yield may indicate a higher risk.
Call Provisions: Understand the call provisions of the preferred stock and assess the potential impact on your investment.
Liquidity: Consider the liquidity of the preferred stock. Some preferred stock issues are thinly traded, which can make it difficult to buy or sell shares quickly.
Tax Implications: Consult with a tax advisor to understand the tax implications of investing in preferred stock.

Preferred Stock vs. Common Stock vs. Bonds

To further clarify the role of preferred stock, let's compare it to common stock and bonds:

Feature	Preferred Stock	Common Stock	Bonds
Ownership	Yes	Yes	No
Voting Rights	Typically No	Yes	No
Dividend/Interest	Fixed Dividend	Variable Dividend (Discretionary)	Fixed Interest
Payment Priority	Before Common Stock	After Preferred Stock	Before All Stockholders
Liquidation Priority	Before Common Stock, After Bondholders	Last	First
Potential Return	Moderate, Primarily Income	High, Capital Appreciation and Income	Low, Primarily Income
Risk Level	Moderate	High	Low

Conclusion

The dividend preference for preferred stock is a critical feature that provides a degree of income certainty and risk mitigation for investors. By understanding how this preference works, along with other characteristics of preferred stock, investors can make informed decisions about whether to include it in their investment portfolios. While preferred stock offers advantages such as fixed income and reduced risk compared to common stock, it also has limitations such as limited upside potential and sensitivity to interest rate changes. Therefore, thorough research and careful consideration of individual investment goals are essential before investing in preferred stock.