Issuing or owning preferred stocks comes with both advantages and disadvantages. Companies generally issue preferred stock as a means of raising funds for their operations and various other reasons. Investors who purchase these stocks commonly do so because of the dividend payments they are entitled to receive. Before we have an in-depth discussion on the various preferred stock advantages and disadvantages to both the issuing company and investor, let us have a look at what preferred stocks mean.
Preferred stock definition
In broad terms, preferred stock is a type of stock that represents ownership in its issuing company just like common stocks. It is a component of the issuing company’s share capital and is considered mixed instrument security because it has the feature of both equity and debt instrument. It can be classified as equity due to the potential of its market value to appreciate over time and it is classified as a debt instrument because its holders are entitled to fix and regular dividend payments.
When the payments of dividends are made by the issuing company, preferred stockholders are given preference over the common stockholders. They get paid first and it is only when the declared distributions remain after they are paid that common stockholders get paid, If nothing remains, it means that the holders of common stocks will not receive dividends.
Preferred stocks are not as commonly issued as common shares hence not all companies that issue stocks issue this particular kind of stock. Companies that issue them generally issued them as a small portion of their authorized shares. Preferred stocks also trade on major exchanges such as NASDAQ (National Association of Securities Dealers Automated Quotations Stock Market) and NYSE (New York Stock Exchange) just like common stocks, however, they are usually listed with a different ticker symbol to differentiate them from the common stock of the same company.
There are several types of preferred stocks which include cumulative, participating, adjustable rate, perpetual, monthly income, noncumulative, exchangeable, nonparticipating, convertible, prior, putable and preference preferred stock.
Furthermore, if the issuing company is going through bankruptcy, mergers, acquisitions, or liquidation, preferred stockholders have a higher claim on the company’s assets than holders of common stock. Preferred stocks are also referred to as preferred shares or preference shares or preferred.
See also: Large-cap, mid-cap, and small-cap stocks
Preferred stock advantages and disadvantages
The advantages and disadvantages of preferred stocks are the benefits and drawbacks that these stocks offer to the issuing company as well as the investors that purchase them. We shall outline a few of these advantages and disadvantages in the table below and further discuss them afterward.
|The issuing company retains full control||The company is obligated to pay preferred stockholders dividends|
|The stockholders enjoy fixed and regular dividends||They cannot participate in higher dividend payouts due to the fixed dividend rate|
|Holders of preferred stock have a higher claim on assets during a liquidation||They have no voting rights in the company|
|Preferred stocks have an ownership stake in the issuing company||Preferred stocks are relatively expensive|
|Issuing of preferred stocks provides permanent funding to the company||Dividends are paid in arrears to cumulative preferred stockholders.|
|The issuing company can defer dividend payments|
Advantages of preferred stock
The issuing of preferred stocks offers some advantages to the issuing company and some, to the investors that own them. Let us have a brief look at these advantages of preferred stock within the table below and further discuss them hereafter.
|The company has full control over its decisions||Investors are assured of a fixed income|
|Preferreds are a source of permanent capital||They receive preference during the payment of dividends|
|The income generated from the sale of preferred stocks can be used to finance the company||Owning preferred stocks represents having an ownership stake in the company|
|There is a flexibility of terms when issuing preferreds.||If the company liquidates, the stockholders have a priority claim on the assets|
|Dividend payments can be deferred to the future.||The stocks are convertible to common stock|
|Payments of fixed dividends aid to save on dividend payments||Stockholders can gain when the issuing company repurchases the stocks from them|
Advantages to the issuing company
- Unlike common stockholders that can vote in the decision-making processes of the company, issuing preferred stock aids the company owners to have full control of the company. Since preferred stockholders cannot influence the company’s decisions as they are typically unable to vote in on matters.
- These stocks contribute to the share capital and paid-up capital of the issuing company. Both share capital and paid-up capital is funds gotten from the sale of stocks. The share capital is gotten from the shares’ par value while the paid-up capital is any excess paid alongside the stock par value. This capital is useful for financing various operational and developmental activities of the company.
- Since most preferred stocks do not have a maturity date which means that they do not have to be paid back, they are a good source of long-term financing for the issuing company.
- The terms of these stocks as detailed in its prospectus can be set as the company owners decide. This gives them the flexibility to choose terms that offer the most benefits to the company.
- Although the company is obligated to pay dividends to preferred stockholders, they can choose to defer payments to the future especially when they need the funds for reinvestments or they are financially constrained to fulfill their obligation.
- Since the dividends on preferred stocks are fixed, it aids the company to save money. This is because they do not have to pay a higher dividend even when they make more profits.
Advantages to the stockholder
- Holders of preferred stocks generally earn a fixed income through quarterly, semi-annual or annual dividends which they are entitled to receive from the issuing company.
- When it comes to payments of dividends, preferred stockholders receive preferential treatment over common stockholders by getting paid first.
- Holders of preferred stock also have an ownership stake in the issuing company along with its other stockholders.
- These investors have a secured position and a high claim on the company’s assets in an event of the company’s liquidation.
- Preferred stock could be converted to a preset number of common shares. This feature is advantageous especially when the price of the company’s common shares appreciates as it enables the holder to benefit from the capital gain when converted.
- If the issuing company decides to buy back the preferred stock and its call price is above the stock’s par value, the difference becomes a gain to the stockholder.
Disadvantages of preferred stock
Every investment has its peculiar disadvantages, preferred stock is not exempt from this, and there are some disadvantages associated with either issuing them or owning them. These we shall look at below outline below and discuss afterward
|Payment of dividends||The stocks are usually nonvoting|
|Accumulation of unpaid dividends||There is no increase in dividends|
Disadvantages to the issuing company
- The issuing company is obligated to pay fixed dividends to preferred stockholders.
- When the issuing company fails to pay dividends, the dividends accumulate for holders of cumulative preferred stock and all unpaid dividends must be paid in arrears.
Disadvantages to the stockholder
- The ownership of stocks generally represents an ownership stake in the issuing company, even though this is still true for preferred stockholders, their ownership is limited. This is because they do not have a say in the issuing company because they do not have voting rights and can therefore not participate in the company’s decision-making processes.
- The fixed dividend payment received by preferred stockholders can be a disadvantage, especially in times when the issuing company nets in higher profits and declares a higher dividend payout.
- These stocks are usually sold at relatively expensive prices when compared to common stock.
See also: Advantages and disadvantages of share buyback
In our discussion on preferred stock advantages and disadvantages, we have seen the various advantages and disadvantages that these stocks offer either to the issuing company or to an investor. The advantages that preferred stocks offer to both their issuing company and the stockholder far outweighs their disadvantages.
The issuing company gets access to a permanent capital source which it can utilize for research and development, business expansion, plant and machinery purchase, repayment of the debt, and many other operational needs. When the share capital gotten from the sale of preferred shares is efficiently utilized by the issuing company, the benefits it brings are enormous notwithstanding the fact that they are obligated to pay regular dividends to the stockholders.
Investors who own these stocks are also assured of fixed regular income through the dividend payments they receive. They also have an ownership stake in the company even though they cannot vote on the decisions of the company.
On whichever side of the divide you belong, considering the advantages and disadvantages of these stocks will aid you to choose the right decision as pertains to either issuing or purchasing preferred stocks.
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