What Is a Preferred Stock?
Like common stock, preferred shares of stock give the investor part ownership in a company. Preferred stocks are generally better for income while common stock is preferable for equity growth. Consequently, which is the best choice depends on your investment goals. Since preferred stock usually has higher dividends it can be a good choice as part of a traditional IRA or Roth IRA to provide retirement income. Before you buy a preferred stock, you should learn exactly what preferred stock is and how it differs from common stock.
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Identification
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Preferred stock is called that because it has first claim (ahead of common stock) when it comes to distribution of dividends and also on equity in the event the company is liquidated for some reason. The priority status means preferred stock carries less risk. Although preferred stock does confer ownership, it generally does not give the investor voting privileges at stockholders' meetings.
Function
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Most of the time a company guarantees to pay a fixed dividend on shares of preferred stock as long as funds are available. For some preferred stock, the dividends will be paid at a later date if the company's current financial position prevents disbursing the promised dividend. Because of this feature, financial analysts consider preferred stock a hybrid of common stock and bonds. The price of preferred stock tends to be much less volatile than common stock, which means less risk. On the other hand, it means that it isn't likely to grow in value when common stock in the company appreciates.
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Types
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There are several types of preferred stock. If a preferred stock is cumulative, rather than noncumulative, then any unpaid dividends accrue and will be paid when the company's financial position improves and before any dividends are paid on common stock.
Participatory preferred stock pays a set dividend, but also earns additional dividends that depend on the company's earnings performance.
A convertible preferred stock can be converted into common stock. Some preferred stocks are exchangeable for other securities as well.
Features
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Companies issue preferred stock for much the same reason they issue bonds: to raise money. However, they aren't obligated to redeem preferred stock at a set maturity date. Another advantage for the company is that it does not pay tax on 70 percent of the money paid as dividends. Investors need to know that dividend interest on preferred stocks is not considered capital gains and is subject to regular taxes. Finally, although a preferred stock normally pays excellent dividends, they may not be better than the earnings from comparable bonds.
Considerations
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You buy and sell shares of preferred stock the same way you do common stock: by placing an order with your broker. Before you invest in preferred stock, research the company and the stock carefully, and read the annual report and independent analysts' assessments of the company. Go to the Investor Relations website of the company and get a copy of their preferred stock prospectus and make sure you understand the terms and conditions.
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