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When people talk about buying stocks, they are usually referring to 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 offers the investor the advantages of both these securities.
What is Preferred Stock?
In terms of financing, preferred stock usually occupies a relatively small percentage of the overall mix of a company's funding when compared to common stock or debt. For example, 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, then the interest expense on the bonds serves to reduce a company's tax liability. Interest expense is tax deductible.
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. This feature of preferred stocks provides investors with a reliable source of income.
To summarize, we know that preferred stock dividends act like interest payments on bonds. Companies are committed to paying preferred dividends. Unfortunately, these payments are not tax deductible, like the interest expense on a bond. So why would a company bother issuing preferred stock?
Utilities Issuing Preferred Stock
There are many interesting niches that preferred stocks can fill, and this will become more evident when we discuss the unique features of preferred stock later on. But perhaps the most interesting niche has to do with the utility industry, 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 nuance 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 act very much like interest expense on debt for utilities. This also means preferred stock is used more in the utility sector than anywhere else. If you're looking for some of the best preferred stock offerings on the market today, then you need to take a close look at the offerings of regulated electric and gas utilities.
Characteristics of Preferred Stock
The name "preferred stock" is by no means an accident. 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:
- Payment Preference - dividends on preferred stock are always paid before dividends are paid to holders of common stock.
- Assets - in the event of bankruptcy or liquidation, preferred stockholders are subordinate to bondholders, but would be paid before common stockholders.
- Convertibility - preferred stock can give the holder the right to convert to shares of common stock.
- Non-Voting - preferred shareholders are usually excluded from voting on matters such as the board of director elections.
- Callable - unlike common stock, preferred stock can sometimes be called, or redeemed, at a future point in time. This is 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 now going to discuss. The characteristics of preferred stock enable companies to include features that add to the marketability, and flexibility, of this kind of stock. The features of preferred stock are listed below.
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. 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 characteristic. This feature of preferred stock means that if a company fails to pay its dividend to preferred stockholders, then 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 allowed to pass on its preferred dividend each year, then the investment would quickly lose its marketability. Stated another way, investors often purchase preferred stock for the dividend. If paying the dividend were optional, then the investment loses its value.
Preferred Stock Quotes
We have 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: Public Service Enterprise Group Class A preferred stock, issued with voting rights.
Preferred Stock Ratings
There is no preferred stock rating system similar to what's available 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 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 fairly extensively on this topic, and if you take a look at our publication, you'll see a section called ratios of financial condition.
The ratio you'll want to pay close attention to when evaluating preferred stock is the interest coverage ratio. Generally, the higher a company's interest coverage ratio, the better the chance they can make a dividend payment.
Finally, if you're looking for a proxy for preferred stock ratings, you might 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 a company with a BBB / Baa rating or higher is considered investment grade.
About the Author - Buying Preferred Stock
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