Preferred stock promises a fixed annual cash payment but lacks the nearly unlimited profit potential of common stock. However, preferred shares come in various flavors. Depending on the legal rights that come attached to preferred stock, they could provide price appreciation as well as a handsome fixed cash flow.
Preferred Stock Basics
Preferred shares entitle the holder to a fixed annual cash payment; in this regard they are more similar to bonds than common shares. While bond payments constitute a legal obligation, however, the firm's board of directors can indefinitely suspend payments to preferred stockholders. The good news is that when the cash crunch passes and the firm is once again able to pay its shareholders, all missed payments on preferred stock have to be honored before common shareholders can receive anything. Should the firm be dissolved due to financial distress, any money left over after paying creditors goes to preferred stockholders before common shareholders are paid.
Interest Rate Swings
Although the maximum amount that preferred stockholders can receive in the form of dividends is fixed by the prospectus -- the legal document issued along with the stock -- preferred stock can appreciate for many reasons. First, as interest rates go down, the price of preferred shares tends to go up. If banks pay 5 percent per year on deposits, for example, preferred stock issued by safe and trusted corporations would also have to yield that much; both investments result in the same income stream with once yearly cash payments. A preferred stock with a $5 annual dividend would be worth $100, since this results in a 5 percent annual yield. Should bank rates drop to 2.5 percent, the share price would climb to $200. After all, for a $5 annual payment to correspond to 2.5 percent of the initial investment, the stock price would have to be $200; 2.5 percent of $200 makes $5.
Preferred shares may appreciate even without a fluctuation in interest rates, if they are exchangeable into common shares. If the prospectus gives preferred shareholders the right to exchange each of their shares into a fixed number of common stocks, an increase in the price of common stock would result in price appreciation of preferred shares too. A preferred stock trading at $100 may be exchangeable into five common shares, for example. If each common share is trading at $18, the exchange doesn't make financial sense. When the price of a common share climbs above $20, however, each preferred share will be worth more than $100 as shareholders can convert them into five common shares and sell these for a total of more than $100.
Many preferred shares are callable by the issuer. In other words, the issuing firm can pay a predetermined sum of money for each preferred share and buy them back at its discretion. This allows the firm to stop making annual cash payments and is a right that firms tends to use when they have a great deal of money at hand. However, the prospectus almost always mandates the issuer to pay more than the original value, also known as the face value, of each share to buy them back. When issuers activate the call clause and buy shares back, the preferred shareholders usually register a profit as they tend to get more for the shares than they paid to acquire them.
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