Preferred Dividend

Preferred dividends refer to dividends that are paid on preferred stock, a class of ownership in a corporation that has a higher claim on its assets and earnings compared to common stock. Preferred dividends are typically fixed and are prioritized over common stock dividends, meaning they must be paid out before common stockholders receive any dividends.

Preferred stock, also known as preference shares, combines features of both equity and debt instruments. Like common stock, preferred stock represents a share of ownership in the company. However, similar to bonds, preferred stock usually does not come with voting rights but promises a fixed dividend, which makes it attractive to income-seeking investors.

Characteristics of Preferred Stock

Preferred stockholders have several characteristics that distinguish their shares from common shares:

  1. Dividend Priority: Preferred dividends must be paid before any dividends can be paid to common shareholders. If a company is unable to pay all of its dividends, it must pay preferred shareholders first.
  2. Fixed Dividends: The dividends on preferred stock are typically set at a fixed rate, which is specified at the time of issuance.
  3. Cumulative Dividends: Many preferred stocks come with a cumulative dividend feature. This means that if the company misses a dividend payment, it must pay the missed dividends in the future before any dividends can be distributed to common shareholders.
  4. Convertibility: Some preferred stocks are convertible, meaning they can be converted into a predetermined number of common shares under certain conditions.
  5. Callability: Preferred stock may be callable, meaning the company has the right to repurchase the stock at a specified price after a defined date.
  6. No Voting Rights: Preferred shareholders typically do not have voting rights in the company, although some preferred shares may provide limited voting rights in certain circumstances.

Types of Preferred Stock

Preferred stock can come in various forms, each with unique features tailored to specific investor needs:

  1. Cumulative Preferred Stock: This type ensures that if a company skips a dividend payment, the owed payments accumulate and must be paid out before any common stock dividends.
  2. Non-Cumulative Preferred Stock: This type does not have the cumulative feature, meaning skipped dividends do not accumulate.
  3. Participating Preferred Stock: These shares offer preferred shareholders the right to receive extra dividends if the company achieves certain financial goals.
  4. Convertible Preferred Stock: These can be converted into common shares based on predetermined conditions, spanning a set period or under specific scenarios.
  5. Perpetual Preferred Stock: Perpetual preferred shares have no maturity date, which means they provide dividends indefinitely, representing a perpetual income stream.
  6. Adjustable-Rate Preferred Stock: Dividends on adjustable-rate preferred stock vary and are tied to an external benchmark, such as LIBOR, resulting in varying dividend income.

Calculation of Preferred Dividends

The calculation of preferred dividends is straightforward. It typically involves multiplying the fixed dividend rate by the par value of the preferred stock.

Formula: [ \text{Preferred Dividend} = \text{Dividend Rate} \times \text{Par Value} ]

For example, if a company issues preferred stock with a $100 par value and a 5% dividend rate, the annual dividend per share would be: [ \text{Preferred Dividend} = 0.05 \times 100 = $5 ]

Financial Impact of Preferred Dividends

Preferred dividends impact a company’s financial statements in several ways:

  1. Income Statement: Dividends are not considered an expense and do not directly reduce net income. Instead, they are deducted from net income to determine the earnings available to common shareholders.
  2. Balance Sheet: Preferred stock appears in the equity section of the balance sheet, and unpaid cumulative dividends are often listed as a liability under “dividends payable.”

Issuance and Investment Considerations

For Companies

Companies might choose to issue preferred stock for several reasons:

  1. Access to Capital: Preferred stock can provide access to capital without diluting common equity or incurring additional debt.
  2. Dividend Flexibility: Unlike debt, where interest payments are mandatory, preferred dividends can be deferred in tough economic times (if cumulative), providing cash flow flexibility.
  3. Attractive Financing Option: For highly leveraged companies, preferred stock can be an attractive financing option as it does not increase debt ratios.

For Investors

Investors consider preferred stock for:

  1. Stable Income: The fixed dividends offer a stable income stream, making preferred shares attractive to retirees and income-focused investors.
  2. Priority Over Common Stock: In the event of liquidation, preferred shareholders have a higher claim on assets compared to common shareholders.
  3. Less Volatility: Preferred stocks generally exhibit less price volatility than common stocks, providing a relatively safer investment vehicle.

Risks and Downsides

Despite their benefits, preferred stocks come with several risks and downsides:

  1. Interest Rate Sensitivity: Preferred stock prices are highly sensitive to interest rate changes. When rates rise, prices typically fall.
  2. Limited Upside Potential: Preferred stocks tend to offer limited capital appreciation potential compared to common stocks.
  3. No Voting Rights: Lack of voting rights means preferred shareholders have less influence over corporate decisions.
  4. Credit Risk: Credit risk exists if the issuing company faces financial difficulties and cannot pay dividends.

Real-World Examples

Bank of America (BAC)

Bank of America regularly issues preferred shares. For instance, in their stock structure, they have issued several series of preferred stock. The prospectuses and detailed information about those offerings can be found directly on Bank of America’s investor relations page.

General Electric (GE)

GE has also issued various series of preferred stock to raise capital. The details about their preferred stock offerings, including terms and conditions, are available on GE’s investor relations website.

Conclusion

Preferred dividends are a key feature of preferred stock, providing a steady and predictable income stream for investors. Understanding the nuances and characteristics of preferred stock is vital for both investors and issuing companies to make informed decisions aligning with their financial goals and risk tolerance. Investors should weigh the benefits of stable income and dividend priority against the risks of interest rate sensitivity, limited upside potential, and lack of voting rights before investing in preferred shares.