 Personal Finance Powerpoint Presentation. Preferred stock. Preferred to get financially fit by practicing personal finance. Most of this information comes from Investopedia. Preferred stock, which you can find online. Take a look at the references, resources, continue your research from there. This is by Akhilesh Ganti, updated March 8th, 2022. In prior presentations, we've been taking a look at investment goals, investment strategies, investment tools, keeping in mind the two major categories of investments, that being fixed income, typically bonds, equities, typically stocks. Now we're focused more on the equity side of things here with preferred stocks, but in a way you can kind of think of preferred stocks as basically in the middle between the bonds and the stocks because they have some characteristics of both. So remember that when we're thinking about bonds, you can kind of think of them as though you're loaning money to the issuer of the bond, that usually being the government or a corporation in return, you're gonna be receiving typically interest payments and typically a principal payment at the maturity. When you're looking at stocks, normal stocks, if we're talking about common stocks, we're talking about a company which is a separate legal entity, the stocks representing ownership, each stock representing an equal unit of ownership. Usually we're talking about corporations that are publicly traded therefore on an exchange when we're talking about individual investors buying and selling the stocks. The value of the stock for a normal stock, a common stock, is that you have the claim to the equity in the business. So the value of the stock could increase as well as you might be getting dividends. So the future value that you could get from the stock is of course selling the stock. It might go up in value and you could get dividends from it. So keeping that in mind, we're now looking at what is a preferred stock. So the term preferred refers to ownership or equity in a firm. So it's gonna be on the equity side of things. There are two types of equity, common stock and preferred stock. So by far, most of the time when we're thinking about investing in equities and stocks, we're thinking common stock and so that would be the default position unless we're specifically going into the preferred stocks. So preferred shareholders have a higher claim to dividends or assets distributions than common stockholders. Now note that this doesn't necessarily mean preferred stock is better meaning the name could suggest that if you had a choice between common or preferred, you'd prefer the preferred but that's not necessarily the case. They're basically just different in their nature. The reason it's called preferred stock is because like bonds, which bonds have a claim, meaning if you were to get the company liquidated, for example, they would have to pay the bondholders typically, unless the government came in and did some funny, they'd have to pay the bondholders before they paid the stockholders for the claim. So similar thing is gonna be true with the preferred stock. They've gotta pay their obligations there first but that doesn't mean necessarily that you would always invest in bonds or in the preferred stock because on the equity side of things, if the value of the company goes up, the value of the stock will basically go up and possibly your dividends would go up. Whereas when you're talking about bonds, the income is fixed a certain amount. And when you're talking about preferred stocks, the amount of dividends that you're gonna get is more fixed. So it's more secure that you will get it but it's more fixed in nature is the general idea. Understanding preferred stock, preferred shareholders have priority over common shareholders when it comes to dividends which generally yield more than common stock and can be paid monthly or quarterly. So when you're talking about the dividends that are going out, that's gonna be the distribution of earnings for the company. So remember, this is similar, like if you think about a sole proprietorship or a partnership, when the company generates money, the owner, the partner or owner will take money out. It's called a draw for their personal uses at that point. When you're talking about corporations because they're gotta break out all the owners as same units of ownership in the form of stocks, we cannot have one owner drawing out more money than another owner. And therefore we have to make it all uniform. And so we call those dividends. So that means the shareholder cannot take a dividend in of themselves. They have to rely on the company, the board of directors and the company to decide what the dividends will be. The same is true for the preferred stocks as well. The commitment for the preferred stocks, however, is typically something that has to be paid before the common stockholders. That's why it's preferred. But typically it's gonna be, it might have more of a limit to it even if the company's value goes up. Okay, so these dividends can be fixed or set in terms of a benchmark interest rate like the London interbank offered rate. That's the Lieber and are often quoted as a percentage in the issuing description. So adjustable rate shares specify certain factors that influence the dividend yield and participating shares can pay additional dividends that are reckoned in terms of common stock dividends or the company's profits. The decision to pay the dividend is at the discretion of a company's board of directors. So usually the preferred stock still is gonna be subject to the discretion of the board of directors like the common stock to determine whether or not they're going to pay the dividend. However, it may be structured in such a way that if they do not pay the dividend, that they might have to pay the unpaid dividends in future years before they pay the common shareholders would be a structure that might be in place with the preferred stock. So unlike common stock, preferred shareholders have limited rights which usually does not include voting. So the preferred stock you might think that just a name would imply that you would think, well, they got everything the common stock has and then it's preferred, right? Well, no, that's not how it works. They don't have the same kind of voting right. The preferred name is designated to specific things meaning they should get allocated their dividends and whatnot or get paid before the common shareholders. So they don't have the same voting rights as the common shareholders, which means the common shareholders you can kind of think of as more of kind of like the owners of the company to some degree and the preferred stock having some, some, you know, interplay or some investment that has some characteristics of a bond and some characteristics of the stock. So preferred stock combines futures of debt and that it pays fixed dividends and equity and that it has a potential to appreciate in price. This appeals to investors seeking stability and potential future cash flows. So clearly if you want more of a fixed income component most of the times, most investors think of basically the equities as their equity investments and on the fixed income side of things your main source might be some kind of bonds but the preferred gives you more of that that fixed income kind of feel to it as well. So it's kind of an in-between zone from the characteristic of how the instrument is acting from an investment standpoint. So if a company is struggling and has to suspend its dividends, preferred shareholders may have the right to receive payment in arrears before the dividend can be resumed for common shareholders. In other words, the company has the capacity not to pay out typically dividends to both common shareholders and the preferred. However, they may result in them having to pay the backed up dividends that they did not pay in the past dividends in arrears before they pay the common shareholders the way that if depending on how the preferred dividend is structured. So shares that have this arrangement are known as cumulative. So cumulative, if a company has a multiple simultaneous issues of preferred stock these may in turn be ranked in terms of priority. The highest ranking is called prior followed by first preference, second preference, et cetera. So preferred shareholders have a prior claim on a company's assets if the liquidation though they remain subordinate to bondholders. So this is once again, the preferred stocks kind of being in between bonds and stocks. Meaning if the company liquidated it went out of bensness, it went bankrupt. For example, they typically need to pay their liabilities first. So they would sell their assets that get cash typically. They pay off the liabilities which would be the third party people and then they would pay the owners preferred share bondholders first and then the preferred shareholders and then the common shareholders. So common shareholders are lasted line. That doesn't mean that the common shares are not as good though because if the company does well the common shareholders typically have more potential to benefit from it from there. So there's less security but more upside on and that's how risk will typically work oftentimes. So preferred shares are equity but in many ways they are hybrid assets that lie between stock and bonds. They offer a more predictable income than common stock and are rated by the major credit rating agencies. Unlike bondholders, failing to pay a dividend to preferred shareholders does not meet a company is in default. So if a company doesn't pay its debt obligations, it's bonds, they go into default. They don't have that kind of situation typically with the preferred stock although they might have the dividends in a rear kind of situation. Because preferred shareholders do not enjoy the same guarantees as creditors the ratings of preferred shares are generally lower than the same issuers bonds with the yields being accordingly higher. Voting rights and call, voting rights, calling and convertibility. Pervert shares usually do not carry voting rights so unlike the common stocks. Although under some agreements these rights may revert to shareholders that have not received their dividend. Preferred shares have less potential to appreciate in price than common stock and they usually trade within a few dollars of their issue price. So you're not gonna see as much volatility much change in the price. Which of course is why you buy the common stock if you're looking for increases in the value of the investment. Whereas the preferred stock you got more of a fixed income kind of situation with the dividends. So most commonly $25. So whether they trade at a discount or premium to the issue price depends on the company's credit worthiness and the specifics of the issue. For example, whether the shares are cumulative, their priority relative to other issues and whether they are callable. If shares are callable, the issuer can purchase them back at par value after a set date. So I think we talked about callable options in the prior presentation. So if interest rates fall, for example, and the dividend yield does not have to be as high to be attractive, the company may call its shares and issue another series with a lower yield. So the call option is usually a benefit to the issuer of the preferred stocks in a similar way as when they issued the bonds kind of situation. So that means it's gonna be not as good a benefit for the investor side of things generally. So shares can continue to trade past their call date if the company does not exercise this option. Some preferred stock is convertible, meaning it can be exchanged for a given number of common shares under certain circumstances. So similar kind of condition with the convertible on the bond situation. So we might be able to have this benefit. This would be a benefit on the investor side of things to be able to convert to common stock. The board of directors might vote to convert the stock. The investors might have the option to convert or the stock might have a specified date at which it automatically converts. So again, we got kind of some different scenarios obviously who would be beneficial from those different scenarios would change somewhat. So the board of directors might vote to convert the stock. The investor might have the option to convert that would be more beneficial to the investor or the stock might have a specific date at which it automatically converts. Meaning now it's just gonna be triggered by the fact that the date, you know, once the date is hit. So whether this is advantageous to the investor depends on the market price of the common stock. Typical buyers that preferred stock who buys the preferred stock, when would you be putting money into this? Because most individual investors are usually thinking common stock when they're investing in stock and bonds when they're thinking of investing in fixed income. The preferred stock that it doesn't seem like preferred stock is that complicated but just a couple levels of complexity actually add a lot more complexity to the investment instruments. A lot of times the simplicity is what you want, right? That's why you invest, that's why they made common stocks as the same shares. They're all the same, they're simple in nature and they're all comparable in nature. Bonds are more comparable in nature because if they're lined up in the same, once you add like another, a couple of these convertible features and this kind of stuff, then the level of complexity that's applied to them when you try to fit them into your investment portfolio can be more tricky than you would think of at first. So in any case, preferred stock comes in a wide variety of forms and is generally purchased through online stock brokers by individual investors. The features described above are only the more common examples and these are frequently combined in a number of ways. A company can issue preferred shares under almost any set of terms assuming they don't fall foul of laws or regulations. Most preferred issues have no maturity dates or very distant ones. Institutions are usually the most common purchaser of preferred stock. This is due to certain tax advantages that are available to them which are not available to investors. Notice this is a component that makes them a little bit different than bonds because you have that income string that's kind of set that's similar to bonds but they don't have that maturity date as bonds do. So that makes it a little bit different in terms of how you're gonna value the preferred stock in terms of future payments that you expect to receive, for example, because these institutions by and bulk preferred issues are a relatively simple way to raise large amounts of capital. Private or public companies issue preferred stock to for this reason. Preferred stock issuers tend to group near the upper and lower limits of the credit worthiness spectrum. Some issue preferred shares because regulations prohibit them from taking on any more debt or because they risk being downgraded. So a company if they can't take on the debt then they might use an equity instrument which is kind of close in structure to the debt which would be the preferred stock. While preferred stock is technically equity it is similar to many ways to a bond issue one type known as trust preferred stock can act as debt from a tax perspective in common stock on the balance sheet. So that you would think in form it looks like one thing but in structure it's kind of another thing, right? So they might end up using that for kind of technical reasons once again. While preferred stock is technically equity it is similar in many ways to a bond one type known as trust preferred stock can act as debt from the tax perspective in common stock on the balance sheet. So on the other hand several established names like General Electric Bank of America and Georgia Power issue preferred stock to finance projects. So in other words you might you don't want to think that the preferred stock is just for a company that's that can't get any more debt financing. Some they might use it for specific reasons such as funding a project. So what are the advantages of a preferred stock? A preferred stock is a class of stock that is granted certain rights that differ from common stock. Namely preferred stock often possesses higher dividend payments and a higher claim to assets in the event of liquidity. So in addition preferred stock can have a callable feature which means that the issuer has the right to redeem the shares of a predetermined price and date as indicated in the prospectus. In many ways preferred shares a similar characteristics to bonds and because of this are sometimes referred to as hybrid securities kind of a combination between the bonds and the equity common stock. What is the difference between a preferred stock and a common stock? Well preferred stock and common stock are both equity instruments. They share important distinctions. First, preferreds receive a fixed dividend as dividend obligations to preferred shareholders must be satisfied first. Common shareholders on the other hand may not always receive a dividend. Secondly, preferred typically do not share in the price appreciation or deep appreciation to the same degree as the common stock. So that would be the advantage on the common stock side of things. If the company does well, well if it's an advantage, if it does well, you have more benefit to the upside because your stock price will typically go up whereas it will not go up so much with the preferred stock which makes it similar to the bond in that way. So lastly, preferred typically have no voting rights whereas common stockholders do. So obviously the common stocks have an advantage there and having the capacity for voting rights. So what is an example of preferred stock? Consider a company issuing a 7% preferred stock at a $1,000 par value in turn. The investor would receive a $70 annual dividend or $17.50 quarterly. Typically this preferred stock will trade around its par value behaving more similarly to a bond. Investors who are looking to generate income may choose to invest in this security. The most common sector that issues preferred stock is the financial sector where preferred stock may be issued as a means to raise capital.