What are "preferred" stocks? How are they different from normal (common) stocks?

Question

What are "preferred" stocks? How are they different from normal (common) stocks that you can buy on a stock exchange?

Answer 1

It is just a different category of stock issued by a company that gives its owners different treatment when it comes to dividend payment and a few other financial transactions.

Preferred stock holders get treated with some preference with regard to the company's profits and assets. For example, dividends are typically guaranteed to preferred stock holders whereas the leadership in the company can elect at any time not to pay dividends to common stockholders.

In the event the company is liquidated, the preferred stockholders also get to be in line ahead of common stockholders when the assets are distributed.

Answer 2

I seem not to be able to comment on the first answer due to reputation, so I'll aim to enhanced the first answer which is generally good but with these caveats:

1) Dividends are not "guaranteed" to preferred shareholders. Rather, preferred shareholders are normally in line ahead (i.e. in preference to or "preferred") of common shareholders in terms of dividend payment. This is an extremely important distinction, because unlike investments that we generally consider "guaranteed" such as CDs (known as GICs in Canada), a company's board can suspend the dividend at anytime for long periods of time without significant repercussions -- whereas a missed payment to a bank or secured bondholder can often push a company into bankruptcy very quickly.

2) Due to point 1), it is extremely important to know the "convenants" or rules sorrounding both the preferred shares you are buying and the other more senior creditors of that issuing company (i.e. taxes (almost always come first), banks loans, leases, bonds etc.). It is also important to know if a particular preferred share has "cumulative" dividends. You generally only want to buy preferred's that have "cumulative" dividends, since that means that anytime the company misses a payment, they must pay those dividends first before any other dividends at the same or lower priority in the future.

3) Unlike a common stock, your upside on a preferred stock is relatively fixed: you get a fixed share of the company's profit and that's it, whereas a common shareholder gets everything that's left over after interest and preferred dividends are paid. So if the company does really well you will theoretically do much better with common stock over time.

For the above reasons, it is generally advisable to think of preferred shares as being more similar to really risky bonds in the same company, rather than similar to common stock. Of course, if you are an advanced investor there are a lot more variables in play such as tax considerations and whether the preferred have special options attached to them such conversion into common shares.

Answer 3

I know this has already been answered and I know its frowned upon to dump a link, however, when it comes to investments it's best to get data from an 'official' source to avoid misinterpretations and personal opinions. The attached pdf is from the S&P and provides detailed, but not overwhelming, information regarding the types of preferreds, the risks & common terminology:

http://us.spindices.com/documents/education/practice-essentials-us-preferreds.pdf

Page 1:

PREFERRED SECURITIES DEFINED

Borrowing from two worlds, a preferred security has both equity and fixed income characteristics. As such, the preferred structure offers a flexible approach to structuring a preferred offering for an issuer.

Companies have many reasons to issue preferred securities. Financial institutions, for example, need to raise capital. Many times they will use the preferred market because of any required regulatory requirements, in addition to cost considerations. Banks and financial institutions are required to maintain a certain level of Tier 1 capital—which includes common equity and perpetual non-cumulative preferreds—as protection against the bank’s liabilities. Issuing more common equity comes at a cost, including the dilution of existing shares, which a company may not want to bear. Preferred securities are a cheaper alternative approach to raising the capital.

Companies often use preferred stock for strategic reasons. Some of these uses include:

• Balance sheet management as a way for a company to potentially lower its debt- to-equity ratio by issuing preferred stock as opposed to traditional debt, thus keeping its ratio lower.
• The company’s credit rating. Credit rating agencies often award an “equity credit” to preferred securities in the analysis of capital structure. All other things being equal, this may contribute to more favorable analysis by ratings agencies for the preferred issuance, as opposed to a bond issuance.
• In cases of a merger, the acquiring company is not responsible for the preferred stock or debt of the target company. The company may choose to continue the obligation or can decide not to, depending on the situation and other political ramifications.
• When a company is facing bankruptcy, the courts will decide the settlement, but the ranking of security capital prioritization has been defined by whether the capital raised was through borrowing or selling ownership. Preferreds fall between the two approaches, so they are more senior than equity, but junior to other forms of debt.