Moneyzine
/Investment Guides /Buying Preferred Stock

Buying Preferred Stock

Moneyzine Editor
Author: 
Moneyzine Editor
6 mins
January 9th, 2024
Advertiser Disclosure
Buying Preferred Stock

When investors talk about buying stocks, they're typically referring to shares of common stock. But preferred stock offers the investor the advantages of both common stock and bonds, and is oftentimes a compromise worth pursuing. In terms of financing, preferred stock usually occupies a relatively small percentage of the overall mix of a company's capitalization; typically accounting for less than 10% of a company's overall source of funds. That's because from a tax standpoint, preferred stock is treated as equity, but the requirements for dividends are more like bond payments.

Preferred Stock

Since preferred stock is considered an equity security, the dividends paid are taken on an after-tax basis, just like common stock. If the company were to issue bonds instead of preferred stock, then the interest expense on the bonds serves to reduce the company's tax liability; since it's tax deductible. The amount of dividends paid on preferred stock is usually fixed. This means as long as a company is not on the verge of bankruptcy, they will be paying dividends on their preferred shares on a regular basis. This feature of preferred stocks provides investors with a reliable source of income. Most companies treat the payment of preferred stock dividends like their bond payments. Unfortunately, these payments are not tax deductible, like the interest expense on a bond. So why would a company bother issuing preferred stock?

Utilities Issuing Preferred Shares

There are many interesting niches that preferred stocks can fill, and perhaps the most interesting has to do with the utility industry. Most electric and gas utilities go through a rate-setting process that involves constructing a cost-of-service study. Without getting into the details of how rates are set, there is one nuance about this process that makes preferred stock very attractive to utilities. Specifically, preferred stock dividends are treated like an expense for rate-making purposes.

As the name implies, preferred stocks may carry certain features such as payment preference, convertibility, and callability
Moneyzine EditorMoneyzine Editor

That means utilities can pass on the cost of the dividend payment in the rates they charge their customers. Under these conditions, dividends on preferred stock act very much like interest expense on debt. This also means preferred stock is used more in the utility sector than anywhere else.

Characteristics of Preferred Stock

The name "preferred stock" is by no means an accident. This class of stock has characteristics that are "preferred" over common stock. The following is a list of the most common characteristics, which serves as a proxy for a preferred stock definition:

  • Payment Preference: dividends on preferred shares are always paid before those associated with common stock.

  • Assets: in the event of bankruptcy or liquidation, preferred stockholders are subordinate to bondholders, but would be paid before common stockholders.

  • Convertibility: provides the holder with the right to convert to shares of common stock.

  • Non-Voting: preferred shareholders are usually excluded from voting on matters such as the board of director elections.

  • Callable: unlike common stock, preferred shares can sometimes be called, or redeemed, at a future point in time. This is often after a predetermined date, and at the discretion of the issuing company.

Features

Some of the characteristics of preferred stock feed right into a discussion of their features. These characteristics enable companies to include features that add to the marketability, and flexibility of these securities as demonstrated below.

Callable / Redeemable

A preferred stock is said to be callable, or redeemable, when the issuing company has a right to redeem the outstanding shares. This is a common feature and gives the issuing company the ability to use these shares for a specific funding purpose. The price at which the stock is callable is usually stated in terms of its par value.

Convertible

Holders of preferred stock are sometimes offered the option of converting their shares into common stock at a predetermined ratio. This convertible feature is attractive to shareholders because they are entitled to the steady stream of dividends, plus they can enjoy appreciation in value if the price of the company's common stock rises.

Participating

When a security is described as participating, shareholders participate in the dividends of common shareholders. Participation is usually done at a predetermined rate. For example, if a 7% preferred stock is said to be fully participating, then not only does the shareholder receive a 7% dividend, but they fully participate in any dividend paid to holders of common stock.

Cumulative

The final feature is the cumulative characteristic. If a company fails to pay its dividend to preferred stockholders, then it must make up that dividend in future years before payments can be made to common shareholders. Nearly all preferred securities have this feature for obvious reasons. If a company could to pass on its preferred dividend each year, the investment would quickly lose its marketability. Stated another way, investors often purchase this security for the dividend; if paying it were optional, the investment loses its value.

Stock Quotes

We have published an entire article dedicated to reading Stock Tickers and Ticker Symbols. Anyone thinking about buying preferred stock will find a table at the end of that article describing how to identify, and find, preferred quotations. Here's an example of how this works. Let's say an investor were to find a quotation for PSEG's (a utility) preferred stock, the symbol might read like this PEGPRA. This symbol is translated as PEG (PSEG), P (preferred stock), R (voting Rights), Class A preferred stock.

Quality Ratings

There is no preferred stock rating system like what's available with bond ratings. But when evaluating a preferred stock, there are some simple rules to keep in mind before committing to any purchase. Investing in preferred stock is like a combination of stock and bond investing. That means it's necessary to understand if the company is financially healthy, and how it stands with respect to cash. Investors need to be sure the company has enough resources to pay its dividends. To get a good feel for a company's ability to make dividend payments, look at the company's financial ratios. We've written extensively on this topic and one of the important metrics to consider when buying preferred shares is the company's interest coverage ratio. Generally, the higher the interest coverage ratio, the better the chance they will make a dividend payment. Investors looking for a proxy for preferred stock ratings might want to consider using the bond rating system. Even though bond rating agencies use slightly different grading scales, a useful rule of thumb is that a company with a BBB / Baa rating or higher is considered investment grade.

Additional Resources

Finding the Best Stocks to Buy
As investors, it's important to know how to go about finding the best stocks to buy. Before it's possible to successfully choose these stocks; however, it's essential to understand some of the fundamentals of evaluating securities.
Moneyzine Editor
Moneyzine Editor
January 18th, 2024
Dividend Paying Stocks
When interest rates are low, retirees and other investors turn to dividend paying stocks to provide them with a reliable source of income. In fact, investing in companies paying high dividend yields is often viewed as the "sensible" or "rainy day" approach to creating an investment portfolio.
Moneyzine Editor
Moneyzine Editor
January 16th, 2024
Value vs Growth Stocks
Investors are constantly faced with the decision between risk and return. The same logic applies to growth versus value stocks. Rationale investors will agree that picking a quality stock is important, but not everyone agrees that value is more important than growth.
Hristina Nikolovska
Hristina Nikolovska
January 19th, 2024
Buying Cyclical Stocks
There is no doubt the stock market presents individuals with a variety of investment opportunities every trading day. One of the opportunities investor should be familiar with is cyclical stocks. As consumers, we are at the mercy of large economic swings or cycles. As investors, we realize these same economic cycles provide us with a chance to grow our investment returns or protect ourselves; if we know what signals to look for.
Moneyzine Editor
Moneyzine Editor
January 9th, 2024
Buying Defensive Stocks
During economic recessions, or market downturns, investors typically add defensive stocks to their portfolios. These stocks can be expected to perform relatively well during all phases of a business cycle, even during difficult economic conditions. In this article, we're going to help define what is meant by a defensive stock. As part of that definition, we're going to explain how to identify these companies. We're also going to talk about the pros and cons of investing in these stocks, including the best time to buy them.
Moneyzine Editor
Moneyzine Editor
January 9th, 2024
Blue Chip Stocks
When investors talk about quality stocks, they'll often use the phrase "blue chip." Unfortunately, even seasoned market analysts can't agree on a definition of this term. But they do agree that blue chip stocks have some very desirable attributes.
Moneyzine Editor
Moneyzine Editor
January 8th, 2024
Diversifying Your Portfolio
With stock ownership, it's certainly possible to have too much of a good thing. Diversity of stock holdings is important, just ask any former employee of Enron. When that company filed for bankruptcy, thousands of employees lost nearly all their savings. In this article, we're going to explain why experts feel investors should avoid putting more than 10% of their portfolio's assets into one company's stock. We'll also explain how to go about diversifying a portfolio, as well as providing an example to demonstrate the positive impact holding an assortment of stocks can have on your return on investment.
Moneyzine Editor
Moneyzine Editor
January 16th, 2024

Contributors

Moneyzine 2024. All Rights Reserved.