Understanding preferred stock is critical for anyone preparing for the Securities Industry Essentials (SIE) exam. Preferred stocks share characteristics of both equity and debt products, offering fixed dividends and a higher claim on assets than common stocks if a company is liquidated. This article delves into the unique attributes of preferred stock and the various types available such as cumulative, participating, and convertible preferred stocks.
Detailed Explanations
Key Features of Preferred Stock
Preferred stocks are a class of ownership in a corporation with a higher claim on assets and earnings than common stock. Preferred stockholders receive dividends before common stockholders and typically have fixed dividend rates. However, they generally do not possess voting rights. Let’s break down these features:
Fixed Dividends: Preferred shareholders are entitled to fixed dividend payments before distributions can be made to common shareholders. This makes preferred stocks more akin to bonds.
Par Value: Most preferred stocks are issued with a stated par value, typically $25, $50, or $100, and the dividend is often expressed as a percentage of this par value.
Dividend Priority: In case of insufficient profits, dividends to preferred stockholders must be paid before any dividends to common stockholders.
Types of Preferred Stock
-
Cumulative Preferred Stock:
- Definition: Holders are entitled to receive dividends in arrears before any dividends can be paid to common shareholders. If a company misses a dividend payment, it accumulates and must be paid out entirely before common dividends resume.
- Real-World Example: A company suspends dividend payments for two years. When it resumes, cumulative preferred stockholders receive the two-year accumulated dividends before any are distributed to common stockholders.
-
Participating Preferred Stock:
- Definition: In addition to the regular dividend, holders may receive additional dividends if the company’s profits exceed a certain level. This adds a potential upside profitability alongside the fixed income.
- Hypothetical Situation: If a company performs exceptionally well, participating preferred stockholders could receive an extra dollar per share on top of their standard dividend.
-
Convertible Preferred Stock:
- Definition: These stocks can be converted into a specified number of common shares, offering capital appreciation potential and favorable in rising stock markets.
- Conversion Example: A holder might convert their preferred shares into a greater number of common shares if the market price of common stock rises significantly above the conversion price.
Visual Aid: Diagram of Preferred Stock Types
graph TD;
A[Preferred Stock] --> B[Cumulative];
A --> C[Participating];
A --> D[Convertible];
Risks and Considerations
Preferred stocks, like any investment, carry risks. Market interest rates can impact their value, and they may lack the growth potential of common stocks. Investors should also consider call risk, where the issuing company might repurchase the stock if interest rates drop.
Visual Aid: Risk Factors Chart
graph TB;
A[Risks] --> B[Interest Rate Risk];
A --> C[Call Risk];
A --> D[Growth Potential Risk];
Summary Points
- Preferred stocks offer fixed dividends and priority over common stock in asset claims.
- Cumulative preferred stocks ensure dividend arrears are paid before any common stock dividends.
- Participating preferred stocks offer additional dividends when profits exceed thresholds.
- Convertible preferred stocks provide an opportunity to convert into common shares, providing potential for capital gains.
Glossary
- Preferred Stock: A type of equity giving shareholders preference over common stockholders in the distribution of dividends and assets.
- Cumulative Preferred Stock: Preferred stock that accumulates unpaid dividends.
- Participating Preferred Stock: Offers additional dividends under certain conditions.
- Convertible Preferred Stock: Preferred stock that holders can convert to common stock.
- Par Value: A nominal face value of a security.
Additional Resources
-
Books:
- “Investment Analysis and Portfolio Management” by Frank K. Reilly
- “Security Analysis” by Benjamin Graham and David Dodd
-
Websites:
### What is one of the main features of preferred stock?
- [x] Fixed dividends
- [ ] Voting rights
- [ ] Majority stakeholder priority
- [ ] High growth potential
> **Explanation:** Preferred stocks provide fixed dividend payments pre-designated by the issuing entity, unlike common stocks which may have variable dividends and voting rights.
### Cumulative preferred stock ensures:
- [x] Dividends in arrears are paid before common stock dividends
- [ ] Additional voting rights are granted
- [x] Dividends can accumulate if unpaid for any period
- [ ] Immediate conversion to common stock occurs
> **Explanation:** Cumulative preferred stock ensures any missed dividends are accumulated and must be paid out before any dividends can be issued to common stockholders.
### When might a participating preferred stockholder receive additional dividends?
- [x] When company profits exceed a specified threshold
- [ ] When the interest rate falls
- [ ] When stock prices decrease
- [ ] When they convert their shares
> **Explanation:** Participating preferred stockholders can receive additional dividends beyond their fixed rate if the company's profits reach or exceed a specified level.
### Convertible preferred stock allows for:
- [x] Conversion to common shares
- [ ] Fixed, unchangeable terms
- [ ] Mandatory holding period
- [ ] Guaranteed higher dividends than common stock
> **Explanation:** These stocks include a feature that allows the holder to convert them into common stock, offering potential for capital appreciation.
### Key risk factors for preferred stocks include:
- [x] Interest rate risk
- [ ] Credit default risk
- [x] Call risk
- [ ] Additional equity risk
> **Explanation:** Preferred stocks' values can be affected by interest rates and may also face call risk, where companies may redeem them if rates drop.
### A company that reprices higher dividends may impact which preferred stock type most?
- [x] Participating
- [ ] Non-cumulative
- [ ] Straight preferred
- [ ] Restricted preferred
> **Explanation:** Participating preferred stocks would be directly impacted as they provide for additional dividends on higher profits.
### Preferred stockholders have priority in what scenario?
- [x] Liquidation over common stockholders
- [ ] Voting on mergers
- [x] Dividend payments over common stockholders
- [ ] Receiving stock splits
> **Explanation:** Preferred stocks have a higher priority in both dividend payments and claims on assets upon a company's liquidation than common stocks.
### Preferred stocks lack which common stock feature?
- [x] Voting rights in general corporate governance
- [ ] Preference in dividend payments
- [ ] Conversion flexibility
- [ ] Cumulative dividend policy
> **Explanation:** Generally, preferred stockholders do not have voting rights typically associated with common stock ownership in the corporation.
### If interest rates increase, what happens to most preferred stocks?
- [x] Their market value typically decreases
- [ ] Their dividend rates are adjusted automatically
- [ ] They convert automatically to bonds
- [ ] Their importance in the capital structure increases
> **Explanation:** Preferred stocks behave similarly to bonds, and typically their market value decreases as interest rates rise, due to the fixed nature of their dividend yields.
### Preferred stocks offer higher asset claim than common stocks.
- [x] True
- [ ] False
> **Explanation:** Preferred stockholders have a higher claim on assets than common stockholders, both in terms of dividend payments and at liquidation events.