Preferred stock is a hybrid investment instrument, as it resembles both common shares and bonds. Preferred stockholders are paid an annual dividend, which depends on the stock's par value and coupon rate. Although preferred stock provides a more stable income stream than common stock, preferred dividends can be cut or suspended under exceptional circumstances.
While all public corporations have common stock, not all of them issue preferred shares. Preferred stock promises the holder a fixed annual dividend payment. Unlike common stock, however, preferred stock does not carry voting rights in the annual meeting of shareholders, in which the board of directors is elected for the next year. Other critical issues -- such as a merger with another corporation or the sale of the corporation -- also are opened to vote in the annual meeting. Only owners of common stock have a say in who manages the company or its long-term strategic direction.
Dividends payable to owners of preferred stock are based on the face value -- also known as par value -- and coupon rate. Assume, for example, that the coupon rate on a preferred stock is 7.5 percent and the face value is $1,000. The annual dividend per share of preferred stock would be $1,000 x 7.5/100 = $75. No matter how profitable the corporation issuing the preferred stock, the shareholders could not receive more than that sum. Owners of preferred shares are therefore like a bank that has lent money to the company. The bank, too, can never hope to get more money than it is owed.
Under exceptional circumstances the company's management can cut or wholly eliminate the dividend paid to shareholders. Corporations tend to take such a drastic step only in case of severe financial distress and with the approval of the board of directors. Unlike a bank or bondholder, who can sue the corporation for unpaid balances, owners of preferred stock have no option but to wait for matters to improve and the board to approve preferred dividend payments. Owners of preferred shares usually receive a fixed dividend, but they can occasionally end up with a smaller dividend check.
When a company cuts or suspends dividends to owners of preferred stock, it cannot legally pay any dividends whatsoever to owners of common stock. This is why these shares are said to have preferred status. In case of bankruptcy, too, owners of preferred shares must receive the full face value of their stock before owners of common stock can get anything from the proceeds of asset sales.
If several years of preferred dividends have been missed and the preferred shares are cumulative, all past missed payments must be paid in full before owners of common stock can get paid. If the preferred stock is noncumulative, however, only the current year's preferred dividend payment must be honored before owners of common stock can receive a dividend too.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.