Preferred stock definition
/What is Preferred Stock?
Preferred stock is a class of equity ownership that has a more senior claim on the earnings and assets of a business than common stock. In the event of liquidation, the holders of preferred stock must be paid off before common stockholders, but after secured debt holders. Preferred stock also pays a dividend; this payment is usually cumulative, so any delayed prior payments must also be paid before distributions can be made to the holders of common stock.
Preferred stock holders can have a broad range of voting rights, ranging from none to having control over the eventual disposition of the entity. Preferred stock may be sold when a company is unable to sell common shares at a reasonable price. In general, preferred stock has features of both debt and equity, since it may have a fixed dividend amount associated with it (as is the case with debt) and can appreciate in value (as is the case with equity).
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Disadvantages of Preferred Stock
Preferred stock has certain disadvantages for both investors and issuing companies. Here are some key drawbacks:
Limited upside potential. Preferred stockholders typically receive fixed dividends, which limits their potential for capital appreciation compared to common stockholders. Even if the company performs exceptionally well, preferred stockholders do not benefit from increased earnings beyond their fixed dividend, missing out on potential gains from rising share prices.
Interest rate sensitivity. The fixed dividends of preferred stocks make them similar to bonds, causing their market prices to be sensitive to interest rate changes. When interest rates rise, the value of preferred shares can decline, as investors seek higher yields elsewhere, making them less attractive during periods of rising rates.
Lack of voting rights. Most preferred stockholders do not have voting rights in corporate matters, limiting their influence over management decisions and company policies. This can be a disadvantage if investors want a say in major decisions such as mergers, acquisitions, or changes in corporate governance.
Dividend payment risk. Unlike bond interest payments, preferred dividends are not guaranteed and can be suspended by the company during financial difficulties. While dividends may accumulate for cumulative preferred stocks, investors still face uncertainty about when or if they will receive these payments.
Call risk. Many preferred stocks are callable, meaning the issuing company can redeem them at a predetermined price after a certain date. If interest rates decline, companies may call and reissue shares at a lower dividend rate, leaving investors to reinvest their capital at less favorable terms.
These disadvantages highlight the trade-offs that investors must consider when choosing preferred stocks as part of their investment portfolio.
Terms Similar to Preferred Stock
Preferred stock is also known as preference shares.