Is Preferred Stock Equity: Everything You Need to Know
Is preferred stock equity? Much of the confusion stems from a misunderstanding between the two types of stock that companies issue to attract investment and raise capital for their operations: common stock and preferred stock.3 min read
2. The Hybrid Nature of Preferred Stock
Is preferred stock equity? Much of the confusion stems from a misunderstanding between the two types of stock that companies issue to attract investment and raise capital for their operations: common stock and preferred stock. Both convey ownership rights to their holders, but differ in the additional benefits that holders of preferred stock have over those owning common stock.
Common Stock vs. Preferred Stock
The most familiar type of stock to most people is called “common stock.” Holders of common stock are individuals or companies with the right to elect new directors to the company’s board and vote on other important issues regarding the oversight of the business. Common stock is considered equity in a company, and in the event that the assets of a company must be liquidated, they are entitled to payments for their stock only after all other claims against the company have been settled. It is not unusual for common stockholders to receive no return on their capital investment if the company fails.
Preferred stock, on the other hand, is a higher class of stock that provides additional benefits that are granted to common stockholders. These can include additional voting rights or guaranteed representation on the board of directors, for instance. The most appealing aspect of preferred stock is the provision that holders receive priority in terms of dividend payments made by the company, the amount of which can be fixed in terms of interest rates and paid according to a negotiated schedule.
The Hybrid Nature of Preferred Stock
While preferred stock does represent ownership of an equity share in a company, as is the case with common stock, it also has characteristics of another form of security, a bond, which is considered a debt.
- Preferred stock resembles a bond or a fixed-income security with its guaranteed rate of payment. However, that payment does not have to be made if the company decides that dividends will not be distributed.
- If the preferred stock is convertible into common stock, it will gain value if the price of the common stock rises, but never fall below the par value should the stock go down.
- Investors tend to purchase preferred stock for the income it provides both while it is held and when it is redeemed, not strictly for the capital appreciation generated through ownership.
- Bonds have a maturity date by which the principal invested will be repaid. Preferred stocks often feature call provisions, which give the issuer the right to redeem the stock at a predetermined value that may be less than the principal after a certain date.
- Although in principal, a company pays out on preferred stock like cash income, it can hold onto the investment and treat it as equity capital.
- A company’s debt holdings can be converted to preferred stock and treated as an equity contribution.
- Preferred stock dividends and bond interest are fixed for the life of each security. However, nonpayment of a bond obligation can be considered a default, whereas payments on preferred stock can be deferred.
Preferred stocks and bonds are safer investments than common stock due to having a higher priority in terms of payment obligations. Bondholders receive payment before preferred stockholders, but both will receive their money before common stockholders.
The trustworthiness of both a preferred stock and a bond largely depend upon the credit rating of the company issuing the security. A credit rating is a reflection of a corporation’s ability to pay its debts. It is subject to change throughout the course of time that a security is held and if it does change, it will affect the price of both the bond and preferred stock, but not its common stock.
As a rule, companies tend to favor debt financing through the issuance of bonds over raising capital through the sale of preferred stock. A key reason is the way each is treated when a corporation is taxed. Interest expense on debt is tax-deductible, and a company can write off part of the interest payment made to bondholders by a percentage of its tax rate. On the other hand, dividends are paid out using after-tax profit and an expense the company cannot deduct.
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