Preferred shares of stock are sold by companies seeking to raise capital without incurring or and without increasing the number of voting shares (common stock) outstanding. Investors are attracted to preferred stock when they are primarily interested in income, but want the opportunity for equity growth as well. Preferred stock offers higher dividends than most common stock with less risk.
Preferred stock is an equity security similar to common stock in that it confers an ownership share in a corporation. However, preferred stock does not have voting rights at shareholders meetings. Preferred shares provide fixed rate income in the form of dividends that must be paid before any common stock dividends. In addition, if the company should liquidate, preferred shareholders must be paid before owners of common stock (although only after all creditors are paid).
When a company sells preferred shares of stock, it guarantees to pay a dividend as long as the company is fiscally able to do so. Many issues of preferred stock also guarantee to pay the dividend retroactively if business conditions force a dividend payment to be skipped. Because of these features, most investment analysts consider preferred shares to be a hybrid of common stock and corporate bonds. That is, preferred shares are income-producing securities but also may grow in value, while the long term value of a bond is limited to its par (face) value.
Depending on the company’s goals, preferred stock can be issued in several forms. Cumulative preferred stock provides that any dividends not paid on schedule accumulate and must be paid if and when the company is able to do so. Convertible preferred stock can be exchanged for common shares under specified circumstances. Participatory preferred stock allows the company to declare and pay additional dividends over and above the guaranteed amount if company profits warrant.
For investors, one attraction of preferred stocks is that they carry less risk than common stock. The priority of preferred shares when dividends are paid plus the fact that preferred shareholders are paid first if a company fails makes preferred less volatile. On the other hand, preferred stock prices are closely tied to the rate of return provided by dividends, so they tend not to appreciate as rapidly as common stock if the company is doing well.
For companies, preferred stock has two main advantages. The money raised by the sale of preferred stock does not have to be paid back, whereas a bond issue must be redeemed on the maturity date. Companies also can write of part of the dividends paid as an expense—a considerable advantage over common stock dividends that are paid out of after-tax corporate profits. When investors are evaluating a preferred stock they should compare the rate of return to that provided by bond issues. Often the two are close together. Then, the advantage of buying preferred stock, which may grow in value as well as provide income, must be weighted against the greater risk of equity loss compared to bond investments.