Preference shares, or preferred stock, refer to a class of equity that carries particular claims over those of common stock equity. Today, we will identify the characteristics of preferred stock, prior to presenting the most typical types of preference shares. Financial managers have introduced different versions of preferred stock equity into the marketplace that allow for greater flexibility. In general, preferred shares are hybrid securities that fall somewhere between stocks and bonds, in terms of risk versus reward characteristics.
Preferred stock dividend payments must be paid prior to those remitted to common shareholders. The preferred stockholder’s rights to property are also superior to common stock equity in the event of bankruptcy liquidation.
Despite these ownership claims, preferred stock does not share the voting rights applicable to common. Generally, preferred shareholders are more so interested with collecting dividend income, rather than the capital appreciation potential of holding common shares.
Preferred shares often trade as perpetuities, where dividends are paid out at a fixed rate with no maturity date. Prevailing interest rates influence fixed-rate preferred share prices. Market interest rates and fixed investments compete with these preferred shares for investor capital.
Because of their fixed dividend payouts, perpetuity share values will not be directly affected by the economic prospects of the firm, if the company remains solvent and out of bankruptcy. Fixed-rate preferred shares do not share in the upside potential of the company through capital appreciation, and investor here are mostly interested in the company’s ability to continue paying dividends.
Adjustable Rate and Participating Preferred Stock
Adjustable rate preferred stock features dividends that are set according to formulas that relate to competing interest rates, such as those paid out upon treasury securities.
Participating preferred stock enables holders to “participate” within the increased earnings of the firm by enabling dividend increases. Additional dividends are authorized upon participating preferred stock according to preset conditions, which are often related to the dividend payouts and increases upon common stock equity.
Convertible Preferred Stock
Convertible preferred stock is convertible into common stock at a set rate. Holders usually carry the option to convert these preferred shares into common upon their own accord. However, corporations may retain provisions that allow these shares to be called and converted into common at management’s discretion. Common shareholders should remain vigilant, in monitoring the balance sheet for the presence of these convertible securities. Future conversion may flood the balance sheet with additional shares of common stock outstanding and dilute ownership positions.