For anyone attempting to do their due diligence on a potential investment opportunity, the task can be a daunting experience. Many investors often misunderstand the confusing legal speak within the SEC filings that publicly traded companies are required to issue. This guide is intended to help investors better comprehend the practice of a preferred stock issuance.
Preferred Stock is something of a hybrid between common stock and bonds or debt. Typically, those shares are paid a regular cash dividend, regardless of company’s financial position to issue a regular dividend to the common shares. Commonly, these types of stocks sell in large blocks, purchased by financial institutions who has several tax advantages over retail investors.
When an investor buys preferred shares, they do so at the par value, a set price that determines the amount the issuer is obligated to pay as a preferred dividend. To determine the preferred dividend’s annual payout, multiply the dividend’s percentage by the par value.
5% preferred stock x $100 par = $5 per year annual dividends
Although preferred shares typically do not show much appreciation they can provide financial institutions with an incentive to stay vested in the underlying security. This type of scenario is the most common example of a Non-Participating Preferred Stock. What this means for the above example is that if 10,000 non-participating shares were issued, regardless of the company’s performance the annual dividend payout will never yield more than the set $50,000. Sounds boring, right?
A simple way to understand the difference between preferred stock and other investment vehicles is to look at how shareholders get treated if the issuer becomes financially distressed. If an issuer does file for bankruptcy and their assets are liquidated to satisfy the bondholders, the preferred stockholders are entitled to any left-over monies before the common shareholders.
Publicly traded companies often need flexibility when it comes to acquiring capital. Preferred stock is issued based on the issuer’s creditworthiness and other related factors. Preferred stock serves as a middle-ground between equity-based common shares, and the debt obligations to bond holders.
Sometimes to entice buyers and compensate for the lack of appreciation in the par value, Participating Preferred Stock is issued for dividend payments more than the price set by the par value.
All preferred stock is either Cumulative or Non-Cumulative. Cumulative is the most characteristic of the preferred stock and derives its name from the accumulation of all delinquent dividend payments owed to the owner.
While it is non-cumulative dividends are rare, they do get produced in situations where a company has a previously established history of making the regular dividend payments to the common shareholders.If the issuer cannot pay the preferred dividend, those shareholders are owed their dividend before the common shareholders can receive any expected profit sharing. Those missed payments are known as “in arrears” and take priority to the common shares claim to the issuer’s assets.
This financial instrument gives investors the opportunity to be shareholder and creditor.The promise of a preferred dividend entitles the preferred stockholders to preferential treatment, second only to the bondholders. Unlike bonds, failure to pay the dividend does not result in default or bankruptcy.
Preferential Treatment Where it Gets Tricky
The motivations for a publicly traded company to issue preferred shares can lead to uncommon occurrences in the issuing terms.
Preferred shareholders can also be granted votings rights if the dividends are in jeopardy of being paid. Often these rare occurrences can lead investors to a better insight into the overall financial picture of a potential investment. That is why it is important always to investigate the motivates of the issuer for offering the preferred shares.