As an investor, preferred stock is a great way of earning steady and predictable returns. So if your primary aim when investing in stocks is to have a stable income, preferred stock is the way to go.
One of the main aims of businesses or corporations is to make money for their owners, in this case, the investors. Normally, investors own these corporations through stocks, which in most cases, can be categorized into two classes: common stock and preferred stock. Each class of stock has its rights, preferences, benefits, and limitations. When it comes to preferred stock, its most important benefit is the preferred dividends, which are often higher and given priority to common dividends.
To perfectly understand what preferred dividends are, it’s crucial to understand the difference between common stock and preferred stock.
The main benefit of owning common stock is the voice that it gives you in addition to the earning potential. Common stocks give you partial ownership in a company, which typically comes with the legal right to vote in major corporate decisions such as in appointing the board of directors or approving mergers.
When it comes to common stock dividends, they are potentially lucrative but can fluctuate greatly. Why is this? Well, a company is not legally obligated to pay common dividends even if it’s making huge profits. For example, a company may choose to reinvest the profits to boost its growth. Unlike preferred dividends, common dividends can rise dramatically and give you huge earnings at no fixed rates. In other words, common dividends can multiply a hundredfold and don’t have to be paid based on a predetermined fixed rate.
A major downside of common dividends is that they have the lowest priority when it comes to getting your money, particularly if the company fails. Normally, creditors will have to be paid in full, and then preferred dividends before common dividends get even a slight glance.
While preferred stocks do not give you any voting rights in a company’s decisions, its main feature is guaranteed dividends, in this case, preferred dividends. Unlike common dividends, preferred dividends must be paid out on preferred stock at a predetermined fixed rate as long as the company declares dividends.
In addition to getting the priority or preferential treatment of being paid before any common dividend is paid, preferred dividends can be a great option if you’re a cautious investor looking for a fairly predictable stream of fixed and steady stock income. In essence, preferred stocks are similar to bonds in the sense that they pay fixed rates of dividends. Hence, you’ll have guaranteed dividends but only as long as the company makes a profit and can issue dividends.
Besides the lack of voting rights, a major downside of owning preferred stock is that your dividends (preferred dividends) will not increase that much even if the company becomes successful as they’re paid at a predetermined fixed rate.
In simplest of terms, preferred dividends are profits that are paid to investors who hold preferred stock in a company. Whether quarterly, semi-annually or annually, preferred dividends are guaranteed payments and must be paid to preferred shareholders but at a predetermined rate. And even if the company doesn’t declare payments for one reason or the other, preferred dividends will be put into arrears and will be paid at a future date, especially if they’re cumulative preferred dividends. Again, preferred dividends have to be paid in full before any common dividend is paid.
It’s also important to note that preferred dividends are based on a percentage of the par value. Par value means face value or stated value. So if you buy a preferred stock with a par value of $100 at a percentage of 8% preferred dividends, you will get 8% x $100 = $8 per share every year. It doesn’t matter whether the stock prices have risen from $100 to $200; your preferred dividends will be paid using the initial stock value (par value), which is $100.
In most cases, it’s more beneficial to own cumulative preferred stock than non-cumulative preferred stocks. When it comes to cumulative preferred dividends, you’ll be guaranteed to be paid all your dividends at the predetermined fixed rate even if you are not paid as initially scheduled. As a result, you’re most likely to receive future lump sum payments if you do not get periodic dividend payments for the current period.
With non-cumulative preferred dividends, the company is not obligated to pay you in the future if it doesn’t issue dividends for any given reason. For instance, if the company decides not to pay dividends and instead use the profits to reinvest in equipment, the company doesn’t have any obligation to pay you at a later date if you own non-cumulative preferred stock. As such, it’s important to target cumulative preferred stock.
Here’s a perfect example of preferred dividends. Let’s assume that Michael Orange owns 200 shares of cumulative preferred stock in BlahBlah Corporation. The par value of the stock when he bought it was $100 and the predetermined dividend rate is 6%.
The company will pay Michael 8% (predetermined dividend rate) x $100 (par value) x 200 (shares) = $1600. If the company didn’t pay Michael in the last two years for whatever reason, he’ll stand a chance of earning cumulative preferred dividends of $1,600 (annual dividends) x 2 (number of years) = $3,200.
To this end, owning preferred stock, which comes with preferred dividends, is a great way of earning more reliable dividends than common stock. This is the better option if you’re a cautious investor looking for a steadier and predictable income rather than a long-term growth of your stock portfolio.
As always - this post is not to be taken as financial advice. Please consult a financial advisor before making any financial decisions.