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 When most of us think about buying stocks, we are almost universally talking about buying shares of common stock. But for many investors, buying preferred stock may be a good compromise between common stocks and bonds. That's because preferred stock gives the investor the best of both worlds.
What is Preferred Stock?
It terms of financing, preferred stock usually occupies a relatively small percentage in terms of the overall mix of a company's funding when compared to common stock or debt. Preferred stock typically accounts for less than 10% of a company's overall source of funding. That's because from an accounting standpoint preferred stock is treated as equity, but the dividends paid on preferred act more like bond payments.
Preferred Stock Dividends
Since preferred stock is considered an equity security, the dividends paid on preferred are taken on an after-tax basis - just like common stock. If the company were to issue bonds instead of preferred stock, the interest expense on the bonds serves to reduce a company's tax liability.
Add to this the fact that the dividends on preferred stock are usually fixed in amount. This means that as long as a company is not on the verge of bankruptcy, they will be paying dividends on their preferred shares outstanding.
So to summarize, we see that preferred stock dividends act like interest payments on bonds in that companies are committed to their payment, but the dividends themselves are not tax deductible like the interest expense as they would be with a bond. So why would a company bother issuing preferred stock at all?
Utilities Issuing Preferred Stock
There are lots of interesting niches that preferred stocks can fill and this will become more evident when we discuss the features of preferred stock later on. But perhaps the most interesting niche has to do with utilities and that's worth talking about first.
Most regulated utilities go through a rate-setting process that involves constructing a cost of service study. Without getting into the details of how rates are set, there is one thing about this process that makes preferred stock very attractive to utilities. Specifically, preferred stock dividends are treated like an expense for rate-making purposes.
That means utilities can pass on the cost of the dividend payment in the rates they charge their customers. Under these conditions, dividends on preferred stock acts very much like interest expense for utilities. This also means preferred stock is used more in the utility sector than anywhere else. So if you're looking for some of the best preferred stock offerings on the market today, you really need to take a close look at the offerings of electric and gas utilities.
Characteristics of Preferred Stock
The name "preferred stock" is by no means an accident. In many ways this class of stock has characteristics that are preferred over common stock. The following is a list of the most common characteristics of preferred stock. In many ways, these characteristics serve as a proxy for a preferred stock definition:
- Preference as to the payment of dividends - dividends on preferred stock are always paid before any dividends are paid to holders of common stock.
- Assets - in the even of liquidation, preferred stockholders are subordinate to bondholders, but would be paid before common stockholders.
- Convertibility - preferred stock may give the holder the right to convert to shares of common stock.
- Non-voting - preferred shareholders are usually excluded from voting on things such as board of director elections.
- Callable - unlike common stock, preferred stock can sometimes be called, or redeemed, at a future point in time - often after a predetermined date and at the discretion of the issuing company.
Features of Preferred Stock
Some of the characteristics of preferred stock feed right into the features that we are going to now talk about. These very characteristics of preferred stock enable companies to include such features that add to the marketability and flexibility of this kind of stock. The features of preferred stock include:
Callable / Redeemable
A preferred stock is said to be callable or redeemable when the issuing company has a right to redeem the outstanding preferred shares - usually at its discretion. This is a common feature of preferred stock. This gives the issuing company the ability to use preferred shares of stock for a specific funding purpose. The price at which the preferred stock is callable is usually stated in terms of its par value.
Convertible
Holders of preferred stock are sometimes offered the option of converting their shares of preferred stock into common stock at a predetermined ratio. This convertible feature is attractive to holders of preferred stock because they are entitled to the steady stream of dividends plus they can enjoy appreciation in value if the company's common stock rises.
Participating
When a preferred stock is described as participating, this means preferred holders participate in the dividends of common shareholders. Participation is usually done at a predetermined rate. For example, if a 7% preferred stock is said to be fully participating, then not only does the shareholder get their 7% dividend, but they fully participate in any dividend paid to holders of common stock.
Cumulative
The final feature we will discuss is the cumulative. This simply means that if a company fails to pay its dividend to preferred stockholders, it must make up that dividend in future years before any dividends can be paid to common shareholders. Nearly all preferred stock issued has this feature for obvious reasons. If a company were simply allowed to pass on its preferred dividend each year, the investment would quickly lose its marketability. Stated another way, investors often purchase preferred stock for the dividend. If paying the dividend were optional, the investment is pretty much worthless.
Preferred Stock Quotes
We've got an entire article dedicated to reading Stock Tickers and Ticker Symbols. If you're thinking about buying preferred stock, then you will find a table at the end of that article that describes how you can identify and find preferred stock quotations.
Here's an example of how this works. Let's say you were to find a quotation for PSEG's (a utility) preferred stock, the symbol might read like this PEGPRA. This means you are getting a quotation for PEG (PSEG), P (preferred stock), R (voting Rights), Class A preferred stock. Another way of translation PEGPRA - you would describe this as Public Service Enterprise Group Class A preferred stock, issued with voting rights.
Preferred Stock Ratings
First off, let's clear up any misconceptions. There is no official preferred stock rating system like there is with bond ratings. But when trying to evaluate a preferred stock there are some simple rules you can keep in mind before committing to any investment.
Investing in preferred stock is really a combination of stock and bond investing. That means you need to understand if the company is financially healthy and how it stands with respect to cash. Essentially, you want to be sure the company has enough money to pay its preferred dividends.
To get a good feel for a company's ability to make dividend payments, you should look at the company's financial ratios. We've written pretty extensively on the topic and if you take a look at our publication, you'll see a section we call ratios of financial condition.
The ratio you'll want to pay close attention to when evaluating preferred stock is the interest coverage ratio. In general, the higher a company's interest coverage ratio, the better.
Finally, if you're looking for a proxy for preferred stock ratings, you might also want to consider using the bond rating system. Even though the bond rating agencies use slightly different grading scales, the rule of thumb you can use is that anything above a "B" rating is considered investment grade, while companies with ratings below a "B" are considered junk.
About the Author - Buying Preferred Stock
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