Preferred Dividends: Everything You Need to Know
Dividend investing has been around for almost as long as stocks themselves. Retired folks and investors interested in income from their portfolios look for the highest dividend yield from the safest common stock they can find. But are more options for dividend investors than just common stock dividends. Dividend investors also look for stocks that pay preferred dividends.
Income investors can hold dividend-paying common stock, preferred shares or a combination. The choice depends mainly on the investor’s risk tolerance, desire for stock appreciation, and the amount of income they need to make from their account.
Common dividends are just that, common. Though stock companies are not required to pay dividends, many do. Preferred dividends, on the other hand, are not so common. Most companies do not have preferred shares. Though if they do have preferred shares, the shares pay dividends in virtually every case.
Preferred dividends can be a great source of income for dividend investors. Read on for more information about preferred dividends.
What are Preferred Dividends?
In addition to issuing common shares and bonds, some companies also issue preferred shares. Issuing any of these securities is a way to raise money for the business. When companies raise money by issuing preferred shares, there are different consequences than when issuing common stock or bonds.
If the company chooses to raise money by issuing preferred stock, it must pay a predetermined cash payment to the preferred shareholders. The cash payment is a preferred dividend.
When companies decide on what securities they want to issue to raise capital, they must think about the rights the security owners have over the company. For instance, common shareholders are owners of the company and have the right to vote on company matters. These matters are crucial and include things like mergers, board of directors and many more.
On the other hand, preferred shareholders and bondholders are not owners of the company and do not get a vote in such matters. Preferred shares and bonds have some big advantages over common. For example, they usually come with a higher income than common.
In addition to the higher income rates, the income that investors receive from coupon payments and preferred dividends has a higher priority than common dividends. In other words, companies must pay bond interest and preferred dividends before they even think about paying a common dividend.
There are many differences and similarities between preferred and common stocks.
Preferred Dividends vs. Common Dividends
It would be easy for an investor to think that dividends are cash income and look for the highest-yielding shares regardless of type. However, if you know the differences and similarities, you can use them to your advantage, avoid mistakes and give yourself the best chance of reaching your income goals.
The first difference between common and preferred dividends is the yield that they pay. When preferred stock is issued, the company’s board of directors decides on the dollar amount of each dividend payment based on the parvalue of the shares. At that point, the dividend is set in stone and cannot be changed by the company unless there is financial hardship.
The board of directors decides on the common dividend much differently. The first big difference to know is that common dividend are not required. In fact, common stocks may never pay a dividend. If a board of directors decides to pay a common dividend, they typically stick to the dividend as much as possible. However, the company can cut the dividend completely or lower it from time to time.
Knowing the differences between how a dividend is chosen can be very important for income investors. For instance, if you find a common stock and a preferred stock with the same dividend yield, all else being equal, which one would you choose?
The preferred share comes with an obligation for the company to pay the dividend. There is no obligation with the common shares. Therefore, you’d likely go with the preferred. If you think the company will increase the common dividend over time, you may want to go with the common stock.
Preferred Dividends Formula
When a company chooses to raise money by issuing preferred stock, they use a formula that shows buyers how much they can make on the shares. The company first decided on a par value for the preferred shares. Then they chose a dividend rate for the shares. With those two formula pieces, you can then find out how much they will get each time the company pays the preferred dividend.
The formula looks like this:
Par Value x Dividend Rate = Preferred Dividend
For example, if a company issues preferred stock with a par value of $25 each and a dividend rate of 6%, and the preferred dividend is paid once per year, the dividend would be $1.50 per share or $25 x 6% = $1.50.
If the investor likes the preferred shares, they can buy them. If not, they can pass. The buyer can sell the original shares just like common stock after the initial shares are bought. Therefore, after the original price is set, it can change as shares are trading in the stock market. Keep in mind that the preferred dividend does not change. Therefore, if the price goes down and the dividend stays the same, the rate goes up. For instance, say the original $25 preferred shares fall to $20. It will still receive the annual preferred dividend of $1.50. That means the dividend rate increases to 7.5%.
We can rearrange the original formula to solve for the dividend rate. Let’s take a look…
Dividend Rate Formula
Dividend Rate = Preferred Dividend / Share Price
In reference to the example above, the formula would look like this… 7.5% = $1.50 / $20.
The same is true in reverse. If the price of the preferred shares goes up, the rate goes down. For instance, if the price of the preferred rises to $30, the dividend rate would fall to 5% or 5% = $1.50 / $30.
Changing the formula to show rising and falling share price shows an inverse relationship between the price of the preferred shares and the dividend rate.
Convertible Preferred Stock
Some preferred stocks have additional features like convertibility. Holders of convertible preferred stock can exchange their preferred shares for a predetermined number of common shares. So, the price of the convertible preferred stock is influenced by the common stock price.
In addition, preferred stock with such features typically pays a lower dividend rate. Preferred stock investors should be aware of additional features of preferred stock before investing.
About BJ Cook
BJ Cook is a long-time stock nerd. He has held several roles in the equity research world and earned the right to use the CFA designation in 2014. When he’s not writing for Investment U, you can find him searching for new investment ideas. Outside the investment community, BJ is a die-hard Cubs fan.