A preferred stock is a way for a company to raise money,
like bonds or common stock. I think the
best way to define preferred stock is to look at the differences between
preferred stock, bonds and common stock.
This post will concentrate on comparing common stock and preferred stock. I will attempt to
tackle bonds later.
Preferred stock vs common stock.
Both preferred stock and common stock represent ownership in
a company. Common stock stockholders
have a vote at the yearly stockholder meeting, but preferred stockholders have
no vote. Having a vote is not of much
value unless you own a significant percentage of the outstanding common shares. I am guessing that most of my readers are not
investing a million or more dollars in a single stock, so voting rights are not
much of a right. Preferred stocks do
have an advantage in the payment of dividends.
A company has to suspend paying dividends on the common stock if they
want to stop paying dividends on the preferred stock. It is possible that the company has preferred
stock and it does not pay dividends on their common stock. In that case a company may still have a
commitment to pay the preferred stock dividends. Preferred stock dividends are either
cumulative or non-cumulative. With
cumulative dividends the company can stop paying the dividends but if it
resumes it has to pay those dividends that it missed. With non-cumulative dividends, as you may
guess, the company does not have to pay any dividends it missed. Although preferred stocks with cumulative
dividends may seem better than those that are not, you also have to look at the
company issuing the stock. For example,
JP Morgan Chase recently issued preferred stock with non-cumulative dividends. They are a very solid company, less likely than others to stop paying the dividend.
Preferred stock dividends are usually fixed or in rare
instances tied to an interest rate like Libor.
Common stock dividends can and often change. If we look at a comparison
between the common and preferred shares of JP Morgan stock, we can see the
difference. The JP Morgan class C preferred shares trading at about 26.3 per
share have a dividend yield of about 5.7% in May of 2019. Eight years from now if they are not redeemed,
they will have about the same yield and price. The common stock in May of 2019 has a dividend
yield of 2.94% on the $109 stock. If you
go back to July of 2011 the common shares of JP Morgan were selling at $42 a
share with a dividend yield at that time of 2.38%. If you had purchased the JP Morgan stock back
then, you would have a 159% increase in the value and the dividend based on
your 2011 price would be 7.62%. Of
course, it is easy to go back in time and find examples like that. It is equally easy to find examples where the
stock price fell and the dividend was cut.
So, if you are looking for consistent higher yield now, then the
preferred stock is the better option.
As mentioned in my previous article, qualified preferred
stock dividends have the same tax treatment as capital gains. Common stock dividends, again if they are
qualified dividends, have that same tax treatment. You have to own the stock for a certain
period of time before they get this tax treatment for both preferred and common
stock.
Preferred stock can be rated by an agency like Standard and
Poor’s. These are similar to the ratings
that bonds get. The rating is an indication
of the company’s ability to pay the dividend into the future. The ratings from Standard and Poor’s range
from AAA to C. More about this when we
get to the comparison with bonds. Common
stock is not rated in this way, instead the analysts rate the common stock on
how they feel the value of the stock will increase in the future. Common stock gets a rating like buy, hold or
sell.
To recap, Common stocks have voting rights and preferred
stocks do not. Dividends will have to be
paid on all the preferred stock before a company can pay dividends on common
stock. Preferred stock dividends stay
the same where common stock dividends can go up or down. The tax treatment for common and preferred
dividends is the same assuming they are both qualified and you meet the
ownership requirements. Common and
preferred stock are rated differently.
If you are looking for current income preferred stock is better, for
growth common stock is better.
