Definition
Preferred Stock is a type of equity security higher in rank than common stock. It gives its holders certain advantages, such as a fixed dividend payment before any dividends are paid to common stockholders. If a company goes bankrupt, preferred stockholders also have a higher claim on assets and earnings.
Phonetic
/prɪˈfɜːrd stɒk/
Key Takeaways
<ol><li>Preferred Stock Priority - Preferred stockholders have a higher claim on the company's earnings and assets. This is beneficial in cases of bankruptcy where preferred stockholders will be paid out before common stockholders.</li><li>Dividends - Unlike common stock, preferred stock typically comes with a fixed dividend. This means the owner of the preferred share can expect a fixed payout regularly, making it a more predictable and stable investment.</li><li>Limited Voting Rights - One of the drawbacks of preferred stock is that they usually do not carry voting rights. Therefore, owning preferred stock won’t give an investor any control over the company's day-to-day operations.</li></ol>
Importance
Preferred Stock is an important concept in business/finance because it offers a unique blend of features from both common stocks and bonds, thus providing a considerable amount of financial flexibility and risk management. Preferred stock owners have a higher claim on the earnings and assets of a company, receiving dividends before common stockholders. These dividends are typically fixed and are paid out regularly, much like interest from a bond, which can be an attractive feature for investors looking for steady income. Additionally, in the event of a company’s liquidation, preferred shareholders have a higher priority than common shareholders in the distribution of assets. However, preferred shareholders generally do not have voting rights in the company. Therefore, preferred stocks play a crucial role in capital structure management, income generation, and financial risk mitigation.
Explanation
Preferred stock represents a significant portion of equity capital of a company. One of its main purposes is to provide the company with an additional channel for raising capital other than issuing common shares or taking on debt. Companies often use funds raised from issuing preferred stock to cover a variety of financial needs, such as to fuel growth and expansion, pay off debts, or fund operations. This is particularly beneficial for a company that doesn’t want to further dilute the value of common shares nor take on any additional debt.In addition to serving the company’s capital raising objectives, preferred stock also offers a range of investor-centric benefits. Preferred stockholders are accorded a higher claim on dividends and assets than common stockholders. This allows companies to attract a broader range of investors, particularly those seeking a relatively safer investment with a consistent income stream. Preferred stocks typically come with a fixed dividend, which can make them attractive to income-focused investors. Therefore, for both companies and investors, preferred stock serves an important role within the spectrum of financial instruments available in the market.
Examples
1. Ford Motor Company: In 2009, during the financial crisis, Ford Motor Company underwent a restructuring plan. To raise capital, they issued preferred stocks offering an annual dividend of 6.5%. This allowed investors to gain income while letting Ford generate funds to reboot its operations.2. Wells Fargo: As part of its recovery from the 2008 financial crisis, Wells Fargo issued preferred stocks to raise capital. Investors who purchased these shares were given preference in dividends compared to those who owned common shares.3. Bank of America: After the 2008 financial crisis, Bank of America issued preferred shares to raise capital and to pay back the government’s bailout money. These preferred shares were later bought by Berkshire Hathaway, owned by Warren Buffett, because of the preferential treatment in dividends and liquidation preference over common shareholders.
Frequently Asked Questions(FAQ)
What is Preferred Stock?
Preferred Stock is a type of share which provides dividends to its holders before common stockholders. It carries higher claim on the company’s assets and earnings.
What makes Preferred Stock different from common stock?
Preferred stockholders have a higher claim on the company’s earnings and assets than common stockholders. Also, preferred stock usually pays a fixed dividend, unlike common stocks that may have variable dividends.
Does Preferred Stock come with voting rights?
Generally, preferred stockholders do not have voting rights in the company. However, this can vary depending on the company’s structure and share layout.
What are the benefits of investing in Preferred Stock?
The primary benefits of investing in preferred stock include higher dividend payments before common stockholders and higher claims on assets should the company go bankrupt.
What are the risks associated with investing in Preferred Stock?
While preferred stocks come with benefits, it also presents risks such as interest rate risk and default risk. Also, since they generally don’t have voting rights, investors have limited control over the company’s decisions.
Can Preferred Stock be converted to Common Stock?
Some, but not all, preferred stocks come with a convertibility feature wherein the preferred shares can be converted to a predetermined number of common shares.
How does one buy Preferred Stock?
Preferred stocks can be purchased similarly to common stocks, through brokerage firms. They are listed in the stock exchange and are traded publicly.
How are dividends on Preferred Stock determined?
Dividends on preferred stocks are usually fixed and are stated as a percentage of the par value before the stock is issued.
What happens to Preferred Stock if a company goes bankrupt?
In the event of a company’s liquidation, preferred stockholders have a higher claim on the company’s assets than common stockholders. However, they are still ranked below debt holders.
: Is Preferred Stock a good investment?
: The suitability of preferred stocks as an investment largely depends on an individual’s financial goals. If a steady income from investments is desired, then preferred stocks can be a good choice. However, one must be prepared for the associated risks.
Related Finance Terms
- Dividend Rights
- Par Value
- Cumulative Preferred Stock
- Non-Cumulative Preferred Stock
- Convertible Preferred Stock
Sources for More Information
