When someone purchases stock in an organization, then it refers to a share of equity or ownership in that company. There are currently two types that investors can pursue in today’s market: common stock and preferred stock. When choosing the latter option, then the stockholder can have a higher claim to asset distribution and dividends than someone who only holds common stock.
The details of each preferred stock offering depend on the organization and the issues involved with ownership. It typically offers a higher yield, which can sometimes get paid on a monthly or quarterly basis. Some firms use a benchmark interest rate like the LIBOR to determine the returns paid to investors. Even adjustable-rate shares can have specific factors that eventually influence the dividend yield.
Preferred stock combines features of debt that pay fixed dividends with the equity component that offers the potential to appreciate. That’s why it is an appealing option for an investor who seeks stability with their future cash flows.
These preferred stock advantages and disadvantages are worth reviewing if you’re in the market to expand your portfolio.
List of the Advantages of Preferred Stock
1. Investors with preferred stock receive the first dividends.
If you want to create stable cash flow with your portfolio, then preferred stock is an advantage to consider. Investors that hold this asset will receive the first dividend distributions every time an organization offers one. That means you get the first crack at any profits that a company earns based on the percentage of shares that are under your control. Because some firms offer monthly distributions, a significant stake in a company can create a meaningful source of income.
Most preferred stock owners receive a higher dividend rate than what people owning common stock earn with their investment. Make sure that you pay attention to the history of payments to see what to expect.
2. Some preferred stock provides cumulative shares.
Some forms of preferred stock offer an option for investors that is called cumulative shares. If the organization doesn’t turn a profit for the year, then the unpaid dividends remain an obligation to the investor. Once the business returns to profitability, then all of the unpaid dividends must get remitted to the preferred shareholders before any payments go to the ones holding common stock.
If you want preferred stock in your portfolio that offers this investment opportunity, then you must specifically use cumulative shares.
3. It gives investors a higher claim on any company assets.
If an organization goes through a bankruptcy or liquidation event, then a preferred shareholder has a higher claim on any company assets then someone holding common stock. This advantage is quite enticing for the investor who has a low level of risk tolerance. Holding this asset means that the company will guarantee a dividend each year. If it fails to turn a profit and must close, then you’ll receive compensation for your investments sooner.
Although some situations may dictate that no compensation goes out because higher priority creditors take everything, you have a better chance to recover something than someone holding common stock.
4. You might have the option to trade in your preferred shares for common stock.
Another form of preferred stock is called a convertible share. If you invest in this option with an organization, then it allows you to trade in your investment for a fixed number of common shares. This advantage can be quite lucrative if the equity value of the common stock begins to climb.
Investors also have the option to receive additional dividends above the fixed rate if an organization reaches predetermined profit targets. Additional stipulations can also provide more financial incentives to consider this investment. That’s why it is a relatively low-risk way to create long-term income.
5. The cost of raising capital for share issuance is lower.
Although the lack of voting rights with preferred stock is a disadvantage for investors, it is an advantage for the business. This structure means that the Equity percentage doesn’t go through a dilution process when selling preferred shares as they do with the ordinary ones. The lower risk to investors with this benefit also means that the cost of raising capital for issuing stock is lower with this choice than it is with common shares.
6. Companies can issue callable preferred shares.
Organizations have the right to issue a callable preferred stock. That means they retain the right to repurchase any outstanding shares at their discretion. If the callable shares on the market have a 7% dividend when interest rates fall to 3%, then the business can purchase anything that’s outstanding at the market price to then reissue new preferred stock at the lower dividend rate. That helps them to further reduce the cost of capital, although this issue is another disadvantage that investors must consider.
7. You know what your bottom line will be.
When you purchase preferred shares, the liquidation value of the asset is known immediately. That means you have an idea of what the worst-case scenario will be if the organization goes through an unrecoverable problem. Although you won’t receive the entire investment back in this situation except in rare circumstances, there is still money returning to your pocket. This advantage applies whether it has a term or preferred life to it.
8. Preferred stock receives gradings from rating agencies.
Preferred stocks typically receive evaluation and ratings from today’s major credit rating agencies. That means you can find information about your potential investment from Morningstar, Moody’s, and Standard and Poors. This advantage can give the casual investor a higher level of confidence in the consistency of their dividend payments. It isn’t a guarantee that a return is coming your way, but an agency with a history of paying dividends for 20+ years doesn’t typically fail overnight.
9. There can be some tax advantages to consider with preferred stock.
Common stock dividends get taxed as unearned income at the normal tax rate in the United States. That means you’ll pay the amount that’s based on your current bracket. Although that can be an advantage if your income is in the 10% or 12% range, most preferred stock gets taxed at the capital gains rate instead. That means you won’t pay any taxes if you find yourself in the lower two tax brackets, and then it gets taxed at 15% for the higher ones. Even if you’re in the highest tax bracket, you still pay only 20% with a Medicare surcharge of 3.8%.
That means you can make more of your money start working for your needs. Corporations that receive dividends from preferred stock can exclude 70% of them from their taxable income.
10. It gives a company access to VC firms and angel investors.
Most serious angels and venture capital firms will insist on getting preferred stock in return for their investments. Most expect the founders to retain common stock because of the advantages that this investment vehicle provides. The early rounds of investment may be in the form of convertible notes that go into preferred stock in a later round.
Getting access to the experience of these investors is worth the investment cost for a business. Not only does it motivate entrepreneurs to achieve a better exit, but it also gives them a way to create stronger returns for those who believe in their vision immediately.
List of the Disadvantages of Preferred Stock
1. You don’t receive voting rights.
If you are a preferred stockholder, then you don’t receive the same voting rights as someone that holds common stock. This disadvantage is the tradeoff for the financial benefits that you receive with this status. If you want to have a say in the direction of the company, then this investment choice is not your best option. Although it would take a significant investment to have a controlling share of common stock, some investors would prefer that kind of moneymaking venture – and preferred stock cannot provide it.
2. The time to maturity can be problematic for some investors.
Preferred stocks are a lot like bonds in the way they are structured in the marketplace today. Some of them have a specific maturity date, at which time the company redeems the asset for cash at a predetermined amount. Others may have a perpetual life that doesn’t have a termination date like common stock, remaining outstanding for as long as the firm remains in business.
Since preferred stock usually reacts like bonds to interest rate changes, it is critical for the investor to be aware of any time-to-maturity stipulations that may exist with their preferred investment.
3. Some companies don’t put their profits into dividend payments.
If you get excited about the idea of putting your money to work in a high-growth company, then you shouldn’t expect the benefit of dividends when you own preferred stock. Organizations that focus on growing as the first priority put their excess cash back into the business instead of paying dividends. That’s why most preferred stock owners choose to work with mature agencies that have less need for cash to fund growth. Those are the companies that reward their investors with the most dividends.
4. Guaranteed dividends might not ever get paid.
Preferred stock receives a cumulative dividend when an organization reaches profitability. If the company never makes it out of the red with their finances, then it creates the possibility of never earning the expected dividends. Although this investment option is a low-risk situation, it shouldn’t be confused with a no-risk scenario. You can still lose a lot of money by going in this direction.
If you need something more conservative than preferred stock, then your best option is either a certificate of deposit or a money market account.
5. Preferred stock creates a limited upside potential.
Investors can receive a fixed dividend rate with their preferred stock, but it is not a guaranteed offering. It might even be subject to redemption at the issuer’s option, which means this security behaves more like a bond than it does a stock. That means the shares don’t respond to higher corporate earnings in the same way that common shares do unless you have the conversion feature available to you as an investor.
This disadvantage also applies to the interest rates that are present in the investing marketplace at the time. It is another feature that makes preferred stock more like a bond. When the interest rates go up, then the market price of the shares typically fall.
6. There isn’t much industry diversification for preferred stock today.
Outside of the entrepreneurial startups that use preferred stock as a way to start funding their operations, only the financial services industry typically issues this investment option. That means the prices of most preferred stocks have more sensitivity to events that occur in the banking sector. If you need to reduce risk in your portfolio, then you must limit your investments accordingly to ensure that volatility doesn’t reduce your overall net worth.
Preferred stock can increase your annual income considerably. It is also wise to put no more than 20% of your fixed-income portfolio into these instruments to ensure that the best possible outcome can develop.
7. There is rarely equity growth in preferred stock.
The tradeoff for the lower levels of market risk with preferred stock versus common shares is that there is little movement in the equity value of the investment. Your return comes through the fixed dividends that occur when the organization is profitable. Although your value in the shares won’t necessarily decrease dramatically even with interest rate changes, it doesn’t increase in good times either. If you’re looking for rapid growth to catch up on a retirement account or some other financial need, then this solution might not be the first option to consider.
Only you can decide if an investment in preferred stock is a beneficial choice for your current portfolio. If you are unsure about an opportunity that involves this asset, then this guide should not serve as a replacement for professional advice. You should always speak with a trusted financial advisor before making any changes to your investments.
Preferred stock is an excellent option to consider when you want a low-risk way to start providing income for yourself and your family in the future. You’ll have a good sense of what the yield will be while gaining a double benefit in equity gains with elements of debt. Even if you lose money in liquidation, there is a predictable element to this investment.
The advantages and disadvantages of preferred stock have changed little over the years. Most of them get issued by entrepreneurial startups today, following in the footsteps of the railroad and canal companies in the past. These shares are an option that has fallen out of favor in some circles, but it deserves a second look.
Blog Post Author Credentials
Louise Gaille is the author of this post. She received her B.A. in Economics from the University of Washington. In addition to being a seasoned writer, Louise has almost a decade of experience in Banking and Finance. If you have any suggestions on how to make this post better, then go here to contact our team.