The Basics and Valuation of Preferred Stock
(includes calculator)

Preferred stock is a class of stock ownership in a corporation that offers a higher claim on the assets and of the earnings of the corporation than common stock. Preferred shares pay a fixed dividend and are sold in par value amounts. Often, these preferred stocks are convertible to common stock, and are callable by the issuing corporation. Income-oriented investors often choose preferred stock over common stock.

Peferred stock is equity with priority over common stock regarding dividend payments and the distribution of assets in the case of a liquidation. Preferred stock is a hybrid security in that it offers features of both common stock and debt.

Like common stock, preferred stock offers partial ownership in a company. Unlike common stockholders, though, preferred stock shareholders are not offered the voting rights enjoyed by common stockholders. While preferred stock offers the investor a fixed dividend, the company may choose not to pay this dividend if it lacks the financial ability to do so.

The Downside to Preferred Stock Investing

In addition to losing out on voting rights, preferred shares tend to not appreciate in value as quickly common stock. And, as is the case with bonds, rising interest rates can make preferred stock less valuable.

Types of Preferred Stock

The basic types of preferred stock include:

Cumulative: The cumulative feature of a preferred stock means that if the company withholds any part of expected dividends, these payments are in arrears and must be settled before any other dividends. Most preferred stock carries this attribute.

Callable: This feature gives the issuer the right to redeem the stock at a date and price outlined in the prospectus. Most preferred stock is callable.

Convertible: An option for the preferred stockholder to convert the shares into a fixed number of common shares, at any point after a pre-determined date. While exchanges are initiated by the shareholder, there is sometimes a provision allowing the company to call for the conversion.

Participating: Offers the investor the opportunity to earn a dividend beyond the stated rate as outlined in the prospectus. Most preferred stock is non-participating.

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Preferred Stock Valuation

Because the dividends of preferred stocks are generally fixed, the formula for valuing the stock is similar to that of constant growth with the dividend growth rate held at zero.

* Please note that the Required Rate of Return is the rate of return an investor looks for from a particualr investment.

More about preferred stock investing

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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.

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