What is preferred stock?

A stock, also known as a share, is a financial product you can use to invest in a company. In exchange for your investment, you become a part-owner of that company. There are two main types of stock – the common stock and the preferred stock. The majority of shares for sale to retail investors are common shares. While retail investors can invest in preferred stock, it is more often bought by institutions and funds.

The composition of the value of a preferred stock is twofold, lying between stocks and bonds (sometimes called hybrid securities because of that). Preferred stocks are often compared with the characteristics of bonds. Preferred stocks usually have guaranteed fixed, regular dividend payments in perpetuity and have a maturity date to receive the redemption value.

An organisation can have multiple issues of preferred stock ordered by priority with first, second, or third, et cetera. These preferred stocks are then purchased via a broker such as DEGIRO.

To better understand this product, this article looks at the main characteristics and elements of preferred stock, the differences are compared to common stock, and discusses the advantages and disadvantages.

What is the difference between preferred stock and common stock?

There are several differences between preferred stock and common stock. Below are some of the main differences:

  • Dividends: Not only are preferred shareholders paid dividends before common shareholders, but they typically receive a higher dividend yield. Dividends for preferred stocks are usually fixed at a predetermined rate based on the par value. Dividends for common stock are more variable and are based on the profitability of the company.
  • Voting rights: Preferred stockholders do not get voting rights, whereas common stockholders do. Common stockholders are usually given one vote for each share held and can use their votes to, for example, elect a board of directors or vote on major corporate decisions.
  • Share price appreciation: Preferred stock does not appreciate/depreciate the same way as common stock, resulting in less risk for the investor but also lower gains.
  • Claim to assets: In case of asset liquidation due to, for example, bankruptcy, preferred stockholders have a higher claim to a company’s assets over common stockholders.

Example of a preferred stock

Imagine a company issuing preferred stocks at 7% with a par value of $100, and you own 100 shares. In this case, you would receive $700 of dividends per year. This is calculated by multiplying the indicated percentage of 7% with $100 par, resulting in $7 per share. Multiplying this by the number of shares owned (100) equals $700 in dividends per year. As a preferred stock, the value will trade around the stock's par value and is often used to raise capital.

Types of preferred stock

There are many types of preferred stock. Some of the more common ones are cumulative, participating, convertible and callable:

  • Cumulative preferred stock: With this type of preferred stock, if an organisation has financial issues and therefore has missed dividend payments, it must pay all the missed dividends to preferred shareholders before paying any to common shareholders when times are good again.
  • Participating preferred stock: Holding a participating preferred stock enables the stockholder to receive an additional dividend from a certain profit level. The same counts for additional assets in case of liquidation.
  • Convertible preferred stock: This type of stock can be exchanged for a certain number of common shares. This can be done under specific circumstances, such as the board of directors voting for the stock to be converted or investors receiving the option to convert their stock at issuance. Convertible preferred stock can also be given a date at which the stock automatically converts. The conversion can be advantageous in earning higher dividends, benefit from higher company profits or the increase of common stock price through conversion. Still, it depends on the market price of the common stock.
  • Callable preferred stock: In case of asset liquidation due to, for example, bankruptcy, preferred stockholders have a higher claim to a company’s assets over common stockholders.

It is possible that there is overlap between types of preferred stock. For example, a preferred stock can be considered both cumulative and participating.

What are the advantages of preferred stock?

There are several advantages to holding preferred stocks. They can:

  • combine features of debt and equity
  • pay fixed dividends in pre-defined intervals, which are paid before dividends to common shareholders, and
  • have a higher claim on a company’s assets in the event of bankruptcy.

Preferred stocks also distinguish themselves by being relatively low-risk investments while providing a stable future cash flow. They are also more predictable than common stocks and rated by major credit rating agencies.

What are the disadvantages of preferred stock?

While preferred stocks offer several advantages, you should consider the disadvantages as well. Compared to common stocks, preferred shareholders typically do not have voting rights. Also, while you receive regular dividend payments, there is limited upside potential. Fixed dividend payments are also sensitive to interest rate changes.

Start investing at DEGIRO

At DEGIRO, we offer investing in preferred stocks. You can usually recognise these by the ticker. An example is the stock HUNDP, which stands for Hunter Douglas N.V. Preference Shares. This indicates - Preference Shares – that this stock is a preferred stock.

We are currently not opening US or Swedish preferred stocks due to tax implications, however, there are plenty of others to choose from. Register an account with us entirely online today and start investing in preferred stocks.

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The information in this article is not written for advisory purposes, nor does it intend to recommend any investments. Please be aware that facts may have changed since the article was originally written. Investing involves risks. You can lose (a part of) your deposit. We advise you to only invest in financial products that match your knowledge and experience.

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Note: Investing involves risks. You can lose (a part of) your deposit. We advise you to only invest in financial products which match your knowledge and experience.

Note:
Investing involves risks. You can lose (a part of) your deposit. We advise you to only invest in financial products which match your knowledge and experience.