Preferred Stock

Preferred Stock, also known as Preference Share, is a class of ownership in a corporation that has priority over common stock in the payment of dividends and claims on assets during liquidation. It combines features of both equity and debt instruments, making it a hybrid security. While preferred shareholders hold ownership in the company, they generally lack voting rights, unlike common shareholders.
Preferred stock is widely used by corporations to raise capital while maintaining flexibility in dividend payments and ownership control.

Definition and concept

Preferred stock represents equity shares that carry preferential rights regarding:

1. Dividend payments, and
2. Repayment of capital in the event of liquidation.

In other words, preferred shareholders receive dividends before common shareholders and have a prior claim on company assets if the firm is wound up. However, they do not typically enjoy the same voting power as ordinary shareholders.
Preferred stock is often viewed as a middle ground between bonds and common shares — it provides fixed income like debt but represents ownership like equity.

Key characteristics of preferred stock

1. Fixed dividend: Preferred shareholders usually receive a fixed dividend rate, stated as a percentage of the stock’s par value or as a fixed amount.
2. Priority in dividends: Dividends must be paid to preferred shareholders before any distribution to common shareholders.
3. Priority in liquidation: In case the company is liquidated, preferred shareholders are repaid their capital before common shareholders, but after bondholders and creditors.
4. Limited or no voting rights: Most preferred shares do not confer voting rights, although certain conditions (such as non-payment of dividends) may temporarily grant them voting privileges.
5. Callable or redeemable feature: Companies may issue callable preferred shares, allowing them to repurchase the shares after a specific date at a predetermined price.
6. Convertibility: Some preferred stocks can be converted into a fixed number of common shares after a certain period or under specific conditions.
7. Perpetual or term-based: Preferred stock may be perpetual (no maturity date) or redeemable (repayable after a defined period).

Types of preferred stock

1. Cumulative preferred stock: If a company fails to pay dividends in any year, the unpaid dividends accumulate and must be fully paid before any dividends are distributed to common shareholders.
2. Non-cumulative preferred stock: Dividends not declared in a particular year are forfeited and do not accumulate for future payment.
3. Participating preferred stock: Allows shareholders to receive additional dividends if the company earns exceptionally high profits, after fixed dividends are paid.
4. Non-participating preferred stock: Shareholders receive only the fixed dividend, regardless of company performance.
5. Convertible preferred stock: Can be converted into a predetermined number of common shares, providing investors the potential to benefit from rising stock prices.
6. Redeemable or callable preferred stock: The issuing company reserves the right to buy back the shares at a set price after a specific date, giving flexibility in capital structure management.
7. Adjustable-rate preferred stock: Dividends fluctuate based on changes in benchmark interest rates or other market indicators.

Example

A company issues preferred shares with a par value of ₹100 and a fixed dividend rate of 8%.

• The annual dividend per share = ₹8 (8% of ₹100).
• If the company has insufficient profit in a given year, dividends on cumulative preferred shares will be carried forward.
• In case of liquidation, preferred shareholders will be repaid their ₹100 per share before common shareholders receive any residual value.

Differences between preferred stock and common stock

Differences between preferred stock and bonds

Preferred stock therefore sits between bonds (in safety) and common stock (in ownership rights).

Advantages of preferred stock

For the company:

• No voting dilution: Preferred shareholders typically do not influence management decisions.
• Flexible dividend policy: Companies can suspend dividends on cumulative shares without defaulting legally.
• Improved credit structure: Provides long-term capital without fixed repayment obligations.
• Appeals to conservative investors: Attracts those seeking steady returns with moderate risk.

For investors:

• Fixed, predictable income: Offers stable dividends compared to fluctuating common stock dividends.
• Priority in payout: Greater security in dividends and liquidation compared to ordinary shares.
• Conversion opportunities: Convertible preferreds provide potential upside from share price growth.

Disadvantages of preferred stock

For the company:

• Higher cost of capital: Dividends on preferred stock are not tax-deductible, unlike interest on debt.
• Cumulative dividend obligations: Accumulated unpaid dividends can strain future earnings.

For investors:

• Limited voting rights: Minimal control over corporate governance.
• Interest rate sensitivity: Fixed dividends may become less attractive in a rising-rate environment.
• Lower capital gains: Preferred shares are less likely to appreciate in value compared to common shares.
• Dividend risk: Dividends are not guaranteed; they depend on company profitability and policy.

Accounting and valuation

Preferred stock appears under shareholders’ equity on the balance sheet, usually between debt and common equity. Dividends are treated as appropriations of profit, not as expenses.
The valuation of preferred stock depends on the present value of future dividend payments:
Value of Preferred Stock=Dr\text{Value of Preferred Stock} = \frac{D}{r}Value of Preferred Stock=rD​
Where:

• DDD = Annual fixed dividend per share
• rrr = Required rate of return

For example, if a preferred share pays an annual dividend of ₹8 and investors require a 10% return,
Value=80.10=₹80\text{Value} = \frac{8}{0.10} = ₹80Value=0.108​=₹80

Preferred stock in corporate finance

Preferred stock is an important tool in capital structuring, allowing companies to raise long-term funds without increasing debt obligations. It provides flexibility in dividend payment schedules and can be tailored (convertible, callable, or cumulative) to suit both corporate and investor needs.
Financial institutions, utilities, and startups often issue preferred stock to attract investors who prefer steady returns and lower risk compared to common shares.

Real-world examples

• Banks and financial institutions issue preferred shares to strengthen Tier 1 capital under regulatory norms.
• Startups and venture-backed companies often offer convertible preferred shares to venture capitalists, granting them downside protection and conversion benefits.
• Utility companies frequently use preferred stock for financing because of their predictable cash flows and regulated returns.