Preferred Stock

Preferred stock is a hybrid security that combines characteristics of both common stock (equity ownership) and bonds (fixed income). It is called "preferred" because preferred stockholders have priority over common stockholders for dividends and in liquidation.

Key Characteristics of Preferred Stock

Calculating Preferred Dividends

Preferred dividends are calculated based on the par value and stated dividend rate:

Annual Dividend = Par Value × Dividend Rate

Example Calculations

Types of Preferred Stock

1. Cumulative Preferred Stock

The most common type of preferred stock. If dividends are missed, they accumulate as "dividends in arrears" and must ALL be paid before any common dividends.

Example: A company has $100 par, 6% cumulative preferred stock. It skips dividends for 2 years, then wants to pay common dividends.

Exam Tip: For cumulative preferred, count ALL skipped years PLUS the current year. All arrears must be paid before ANY common dividends.

2. Non-Cumulative Preferred Stock

If dividends are skipped on non-cumulative preferred, those dividends are lost forever. Only the current dividend must be paid before common stockholders can receive dividends.

3. Convertible Preferred Stock

Convertible preferred allows investors to exchange their preferred shares for common stock at a predetermined conversion ratio.

Key Terms:

• Conversion Ratio: Number of common shares received per preferred share
• Conversion Price: Price at which common shares are effectively purchased
• Parity: The price at which conversion creates equal value

Formula: Conversion Ratio = Par Value ÷ Conversion Price

Example: $100 par preferred, convertible at $25

• Conversion ratio = $100 ÷ $25 = 4 common shares per preferred share

Parity Calculations

Example: Preferred trading at $120, conversion ratio of 4:1

• Common parity = $120 ÷ 4 = $30
• If common stock trades above $30, conversion may be profitable

4. Callable Preferred Stock

The issuer has the right to redeem (call) the preferred stock at a specified price, usually at a premium to par value.

Exam Tip: Companies call preferred stock when interest rates FALL because they can reissue new preferred at lower dividend rates.

5. Participating Preferred Stock

Participating preferred may receive additional dividends beyond the stated rate if the company has excess profits.

Example: A 6% participating preferred with $100 par receives:

• Regular dividend: $6.00 per share
• If common stockholders receive $10 per share, participating preferred may receive an additional amount (based on participation formula)

6. Adjustable Rate Preferred Stock

The dividend rate floats with market interest rates, providing some protection against interest rate risk.

Combined Features

Preferred stock features can be combined:

• Cumulative convertible preferred
• Callable participating preferred
• Adjustable rate cumulative preferred

Preferred Stock and Interest Rates

Preferred stock prices move inversely to interest rates (like bonds):

This relationship exists because preferred dividends are fixed. When new preferreds offer higher rates, existing lower-rate preferreds become less attractive.

Preferred Stock in Liquidation

In bankruptcy, preferred stockholders are paid:

1. AFTER all creditors (secured and unsecured)
2. BEFORE common stockholders

Exam Tip: Preferred stockholders have priority over common stockholders but are still subordinate to ALL creditors. They are NOT guaranteed to receive anything in bankruptcy.