Why are preferred shares less valuable than common shares?

Question

In the Intelligent Investor, I read that "the preferred holder lacks both the legal claim of the bondholder (or creditor) and the profit possibilities of a common shareholder (or partner)". I'm a bit confused by this statement. Doesn't the preferred holder also get stock dividends like common stock holder (in fact he gets the first claim on earnings) and he can sell the stock too?

Answer 1

Preferred stock owners get fixed dividends, but no ownership, so their only value is the dividends that they receive. Their value does not go up if the company grows, unlike common stock, which has an ownership claim on assets and a possibility of higher dividends. They instead fluctuate in value with interest rates, since with higher interest rates investors require a higher yield and will not pay as much for fixed payments.

Also, unlike bonds, they don't get their money back unless they sell the stock to someone else, so if the company goes bankrupt they don't get their investment back (unless there are enough assets to satisfy all of the bondholders and creditors first).

Answer 2

In the Intelligent Investor, I read that "the preferred holder lacks both the legal claim of the bondholder (or creditor) and the profit possibilities of a common shareholder (or partner)". I'm a bit confused by this statement.

Yes, "the preferred holder also get stock dividends like common stock holder" and they have payment priority over common stock owners as well. But in the event of bankruptcy and liquidation, long before that decision is made, dividends have long been suspended.

In terms of legal claim, in a liquidation, sequential payment is made to:

• Wages and taxes
• Secured bondholders
• General creditors
• Unsecured bondholders
• Preferred stock
• Common stock

With liquidation, the further down you are on the list, the less likely it is that you get anything.

Answer 3

Preferred stock dividends are not too much like common stock dividends. They are more like bond coupon payments (usually).

Common stock dividends are effectively profits the business made returned to the owners of the business, the shareholders. They are paid at the discretion of the board of directors. Some companies return all their profits to shareholders. Some hold the profits as cash. Some reinvest the profits in growth. Companies do generally state a "dividend policy", which sets some expectation of what dividends will be paid, but in any case, the actual amount paid will be variable, based on how well the business did and what the board of directors thinks is best at the time.

Preferred stock dividends are more like bond coupon payments. Preferred stocks are usually issued at $25 per share (in the US anyway, I don't know about other markets), and dividends will be paid on a regular schedule at a fixed amount per share. The dividend will be set according to interest rates at the time of issue. The company may call the stock, meaning they give back the $25 for each share and they no longer have to make the payments.

The call date can be specified as a specific date, not before a date, or at any time. Calling the stock is a good option for the company if interest rates go down: they can call the stock and then obtain new financing at a lower rate.

Some preferred stock is convertible to common stock, although this isn't very common. This is good for the investor if the business does very well: instead of only getting the regular dividend payment and $25 at the end, they can get a share of common stock which could be worth a lot more than $25 and/or also pay higher dividends.

All these details are laid out in the prospectus, and it's important to read it because while there are some parameters which are typical, there are also plenty of atypical issues. For example I once purchased a preferred which had the option of paying dividends as more preferred stock, rather than cash. Of course once the business wasn't doing so well they exercised that option. If the business recovers I'll make a tidy sum, but more likely they'll just default and I'll get nothing.

The price of preferred stock tends to move like bonds: if interest rates go up then the prices must come down to maintain a competitive yield, and vice-versa. But if the preferred stock has an early call or is convertible, this can offer potential up- or downsides to the investor that can make the price move in a different way. (Did I mention it's important to read the prospectus?)

This is why preferred stock may be worth less (per share) than common stock. Non-convertible preferred stock is effectively a fixed-rate loan, with a best case outcome for the investor that the business doesn't default on the loan. Whereas common stock has no limit on the best case outcome.