Definition
Preferred stock is a type of stock which may have any combination of features not possessed by common stock including properties of both an equity and a debt instrument, and is generally considered a hybrid instrument. Preferred stocks are senior to common stock, but subordinate to bonds in terms of claim and may have priority over common stock in the payment of dividends and upon liquidation. Terms of the preferred stock are described in the articles of association.
Preferred Stock
The stocks of a company can be divided into 2 categories, preferred stock and common stock. Just like a common stock, preferred stock can be defined as a class or form of a company’s ownership. However, preferred stockholders have higher claims on earnings and assets of the company than common stockholders.
Understanding the Differences between Preferred Stocks and Common Stocks
- Pay Outs
To begin with, dividends are paid out first to the preferred stockholders of the company and then to the common shareholders. Also, in the event of bankruptcy, the company must pay off preferred stockholders first before they pay the common stockholders. In other words, if the organization goes bankrupt, the preferred stockholders will receive payments first as they will have prior/higher claim on the company’s assets while the common share stockholders will only receive whatever company assets are left once all preferred shareholders, bondholders and creditors are paid off in full. - Voting Rights
Common stockholders receive voting rights whereas preferred stock shareholders don’t. This means individuals holding common stocks can participate actively in company matters and vote when major decisions are made for the company. - Fixed Dividend
Shareholders of preferred stock are offered fixed dividends by the company. The dividend rate is mostly set keeping the benchmark interest-rate in consideration such as LIBOR. And since preferred stock payments are fixed and there are little or no price fluctuations, it is also referred to as a hybrid financial security.
Types of Preferred Stocks
Generally, there are 4 different preferred stocks. These are:
- Cumulative Stocks
This type gives the shareholders the right to gather/accumulate dividend payouts which were skipped because of financial problems. This means if the company resumes dividend payments later down the line, then cumulative preferred stockholders will first receive all those dividend payments that were missed or skipped earlier. - Non-Cumulative Stocks
Unlike cumulative preferred stocks, in this type, the owners don’t receive the dividend payouts that were skipped. - Participating
Participating preferred stockholders may receive higher dividend payments than the regular ones if the company experiences more profits than expected. - Convertible
As the name suggests, these preferred shares can be easily converted to common stocks.
Further Reading
- Financing with preferred stock – www.jstor.org [PDF]
- The effect of issuing preferred stock on common and preferred stockholder wealth – www.sciencedirect.com [PDF]
- The role of debt and preferred stock as a solution to adverse investment incentives – www.jstor.org [PDF]
- The usefulness of hybrid security classifications: Evidence from Redeemable preferred stock – www.jstor.org [PDF]
- Understanding venture capital structure: a tax explanation for convertible preferred stock – www.jstor.org [PDF]
- Characteristics of firms that issue convertible debt versus convertible preferred stock – www.sciencedirect.com [PDF]
- Venture capital on the downside: preferred stock and corporate control – www.jstor.org [PDF]
- Innovation in preferred stock: Current developments and implications for financial reporting – meridian.allenpress.com [PDF]
- Raising capital using monthly income preferred stock: Market reaction and implications for capital structure theory – www.jstor.org [PDF]
- The effect of preferred stock rating changes on preferred and common stock prices – www.sciencedirect.com [PDF]
