Preferred Stock

Preferred sits between debt and common equity

A simplified capital stack is:

Debt → Preferred stock → Common stock

That order matters most when cash is scarce or the company is liquidated.

Creditors generally have claims ahead of preferred holders.

Preferred holders generally have claims ahead of common shareholders.

Common equity receives the residual.

Dividend priority

Investor.gov notes that preferred shareholders usually receive dividend payments before common shareholders.^[2]

Assume a company has:

• $20 million of preferred dividends due under the applicable terms
• $50 million available for shareholder distributions

The preferred claim is addressed before the board considers what can be distributed to common shareholders, subject to the security terms and applicable law.

Priority is not the same as certainty.

Preferred dividends are not bond coupons

A preferred security can state a dividend rate such as:

6% of liquidation preference

That can look bond-like.

The economics can still differ because:

• dividends may be deferrable
• missed dividends may or may not accumulate
• maturity may be absent
• voting rights can change after missed payments
• redemption can be optional

The prospectus controls.

Cumulative preferred stock

A cumulative preferred security generally preserves unpaid dividends according to its terms.

If a company skips:

$5 million

of cumulative preferred dividends:

the amount can accumulate as arrears before common dividends resume.

That feature materially strengthens the preferred claim relative to noncumulative preferred stock.

Noncumulative preferred stock

With noncumulative preferred:

a skipped dividend may not become a permanent arrearage.

Banks often issue noncumulative preferred stock because regulatory capital treatment can depend on loss-absorption characteristics.

The absence of cumulative rights increases the importance of issuer credit quality.

Liquidation preference

Preferred stock often has a stated liquidation preference, such as:

$25 per share

or:

$1,000 per security

That amount helps define the contractual claim.

It is not a guaranteed market value.

A preferred share with a $25 liquidation preference can trade at:

• $18
• $25
• $30

depending on rates, credit risk, call expectations and market liquidity.

Callable preferred stock

Many preferred issues allow the issuer to redeem shares after a specified date.

If market rates fall:

the issuer may refinance expensive preferred capital.

That creates call risk for investors.

A high coupon can therefore be temporary.

Convertible preferred stock

Some preferred shares can convert into common stock under specified terms.

The security then combines:

• preferred priority
• equity conversion exposure

Conversion can create common-share dilution.

The conversion ratio and trigger terms matter more than the label.

Preferred stock and enterprise value

Enterprise-value analysis can add preferred equity when the operating metric being valued includes earnings attributable to the entire enterprise.

Ignoring a material preferred claim can understate the capital that must be supported before common shareholders receive residual value.

Preferred stock and book value

If a company has:

• total shareholders’ equity: $5 billion
• preferred equity: $1 billion

simplified common equity:

$4 billion

Book value per common share should focus on the equity attributable to common shareholders rather than the full $5 billion.

Interest rates matter

Preferred stock often trades partly like long-duration fixed income.

When market yields rise:

a fixed-dividend preferred can fall in price even if the issuer’s operating results are unchanged.

Credit risk and rate risk therefore interact.

Preferred is not automatically safer than common

Preferred ranks ahead of common in specified claims.

It can still lose substantial value because of:

• credit deterioration
• dividend suspension
• rate increases
• call features
• illiquidity
• structural subordination

Priority reduces one dimension of risk.

It does not eliminate investment risk.

Common mistakes

"Preferred stock is a bond."

No.

"Preferred dividends are guaranteed."

No.

"Liquidation preference equals market price."

No.

"Preferred shareholders always vote like common shareholders."

Usually not.

Read the prospectus or certificate of designation. Identify dividend terms, cumulative status, liquidation preference, call dates, conversion rights, voting triggers and ranking. Preferred securities with the same stated yield can have very different economic risk.