What is “Preferred Stock”?

Preferred stock, or preference stock, are shares of a company’s stock that get preference over, or are ranked higher than, common equity or ordinary shareholders when it comes to payment of dividends. Furthermore, if a company goes into liquidation, its preferred stock holders rank above or are entitled to be paid before ordinary shareholders. In other words, preferred stock has preferential rights when compared to ordinary shareholders.

Sometimes, preferred stock have characteristics that resemble debt, such as fixed rate dividends and a redemption date. The IFRS requires companies to report preferred stock with debt characteristics under debt on the balance sheet and treat any associated dividends as interest in the income statement.

Preferred stock trades in a similar way to bonds. The value of the preferred stock falls when the required yield rises and vice versa.

Key Learning Points

  • Preferred shareholders get ‘preference’ over common shareholders in the distribution of dividends and the claim on assets in the event of a bankruptcy
  • At times, preferred stock may resemble debt. In such cases, IFRS requires companies to report preferred stock as debt in the company’s balance sheet, and the associated dividends as interest in its income statement
  • Types of preferred stock include convertible preferred stock, cumulative and non-cumulative preferred stock, callable preferred stock, and participatory preferred stock
  • When treated as equity, preferred stock dividend is deducted from net income before calculating the basic earnings per share (EPS)

Preferred Stock – Advantages

Preferred stockholders have certain advantages such as the possibility of earning a higher dividend than common shareholders, their dividend payments are fixed or known and more stable, and it helps companies to keep their debt-to-equity ratio low (since preferred stock is usually viewed by analysts as equity rather than debt).

Types of Preferred Stock

Convertible Preferred stock

Convertible preferred stock can be converted into common equity after a specified date. These instruments have characteristics of both debt and common equity. Like debt, these are fixed-income securities that offer a fixed rate of return. Additionally, convertible preferred stock offer some form of protection of the original investment, as holders of such stocks would get paid before common stockholders if a company went bankrupt. They also provide an opportunity for capital appreciation.

If a company’s stock price increases, convertible preferred stockholders can convert their preferred stock into common equity and they are typically considered dilutive for the purpose of calculating diluted earnings per share.

Cumulative and Non-Cumulative Preferred Stock

Cumulative preferred stock protects preferred stockholders if a company cannot pay dividends, due to losses or low cash. It protects them by requiring the company to pay any unpaid preferred dividends before paying any dividends to common stockholders. For example, if $100.0 is due to preferred stockholders each year but the company cannot pay them for two years, then in the third year the company must first pay $300.0 ($100.0 x3) to preferred stockholders. Once they are paid, only then can dividends be paid to ordinary or common shareholders.

In the case of non-cumulative preferred stock, dividends do not get accumulated if the company cannot pay dividends in certain years. Dividend calculations commence afresh each year.

Callable preferred stock add another characteristic, where the company has the option to call in or buy back this type of preferred stock at a predetermined price after a defined date.

Regarding participatory preferred stock, shareholders of such stock are entitled to receive additional dividends (above the fixed dividends) if a company’s profits are in excess of a pre-specified level.

Calculating Basic EPS with Preferred Stock

Given below is some information from the financial statement of a company. Based on this information, the basic earnings per share (EPS) has been computed.

EPS is calculated as net income/number of shares outstanding

The footnotes specify that preferred stock has been treated as equity in the financial statement. Therefore, the net income does not reflect the dividend payable to preferred stockholders. We need to deduct this amount to calculate the net income available to common stockholders.

Next, using this adjusted net income figure, we calculate the basic EPS as follows:

Note that if the preferred stock was considered as debt, this adjustment would not be necessary. The net income would already have reflected the preferred stock dividend as an interest expense, leaving the remaining net income available to common stockholders.