WSU Lexicon: Equity Investments

Preferred Stock

Preferred stock is a hybrid equity security that pays a stated dividend and ranks ahead of common stock for dividends and for claims on assets in liquidation, but behind all debt. It usually carries no voting rights and often has no maturity date.

Compare with common stock, which holds the residual claim and the voting power.

The entry

Dividend Mechanics and the Standard Feature Set

The dividend on preferred stock is quoted as a percentage of par value or as a fixed currency amount per share, and it is declared at the discretion of the board rather than owed as a contractual obligation. Skipping it is not a default event, which is the structural fault line between preferred equity and debt.

Features are layered onto that base. Cumulative issues accrue any omitted dividends as arrears that must be cleared before common shareholders receive anything; non-cumulative issues simply lose the missed payment. Callable (redeemable) issues let the company retire shares at a stated price after a set date, capping upside when yields fall. Putable or retractable issues give the holder the right to force redemption. Convertible issues allow exchange into common shares. Participating issues share in profits above the stated rate, and floating- or adjustable-rate issues reset the dividend against a reference rate.

The entry

Valuing a Preferred Share

A fixed-dividend perpetual preferred is the cleanest application of the perpetuity model in equity valuation: value equals the annual dividend divided by the required rate of return on that specific security. Because the numerator does not grow, the entire result is driven by the discount rate, which makes the price highly sensitive to changes in market yields and in the issuer's perceived credit quality.

When the issue has a defined redemption date or a likely call, the appropriate approach is a finite-horizon present value: discount the stream of dividends over the expected life plus the redemption price, in the same way a bond is priced. Non-cumulative or deeply discretionary structures deserve a higher required return than a senior bond from the same issuer, because the holder absorbs dividend-suspension risk without the enforcement rights of a creditor. Convertible preferreds require valuing the straight preferred component plus the conversion option.

The entry

Where Preferred Shares Appear in Markets and Statements

Issuance is concentrated where regulators or rating agencies reward equity-like capital that does not dilute voting control: banks and insurers, utilities, and REITs. Bank additional tier 1 instruments are the modern descendant of this logic, and they are typically perpetual, non-cumulative and callable. Preferred equity is also the standard instrument in crisis recapitalisations and in venture and private equity rounds, where liquidation preference and conversion rights matter more than the stated dividend.

On the financial statements, preferred stock sits in shareholders' equity when it is perpetual and discretionary, but mandatorily redeemable issues can be pushed into liabilities. The dividend is not an expense and does not reduce net income; it is deducted from net income when computing income available to common shareholders. Cumulative arrears are disclosed in the notes rather than recognised as a liability until declared.

The entry

What Candidates Must Be Able to Do With It

Expect three tasks. First, value a fixed-rate perpetual preferred with the perpetuity relationship, and switch to a finite present value when a call or redemption date is specified. Second, place the security correctly in the capital structure: behind secured and unsecured debt and subordinated debt, ahead of common equity, with the practical consequence that recovery in liquidation is often minimal.

Third, handle it in ratio work. Basic earnings per share uses net income less preferred dividends over the weighted average common shares outstanding, and return on common equity is defined on income and book value attributable to common holders only. Convertible preferreds enter diluted EPS through the if-converted method, where the preferred dividend is added back and the conversion shares are added to the denominator whenever the effect is dilutive. Candidates should also recognise that a suspended dividend signals distress without triggering default.

Common trap

“Preferred stock is safer than the same issuer's bonds because its dividend is fixed and must be paid.”

A preferred dividend is discretionary: the board can omit it without triggering default, and non-cumulative issues never have to make it up. Preferred also sits below every debt claim in liquidation, so it is junior to bonds, not senior.

In practice

Berkshire Hathaway's 2008 Goldman Sachs preferred

In September 2008, Berkshire Hathaway invested $5 billion in Goldman Sachs perpetual preferred stock paying a 10% dividend, plus warrants on common shares. The structure gave Berkshire priority over common holders while Goldman avoided issuing dilutive equity at crisis prices.

Candidates ask

Questions on this term

How is perpetual preferred stock valued?Treat it as a perpetuity: divide the annual dividend by the required return on the issue. A 4 currency-unit dividend at an 8% required return gives a value of 50 per share. Add a redemption value if the issue is callable or dated.
What is the difference between cumulative and non-cumulative preferred stock?With cumulative preferred, any dividend the board omits accumulates as arrears and must be paid in full before common shareholders receive any distribution. With non-cumulative preferred, a skipped payment is permanently lost. Non-cumulative structures are therefore riskier for the holder and command a higher required return; regulators favour them for bank capital precisely because losses stick with the investor.
Do preferred dividends reduce net income or earnings per share?They do not reduce net income, because they are a distribution of profit rather than an expense. They do reduce earnings per share: basic EPS is net income minus preferred dividends, divided by the weighted average number of common shares. The same logic applies to return on common equity, which is measured on the income and book value attributable to common shareholders. Convertible preferreds are handled in diluted EPS via the if-converted method.

Related entries

Common StockCommon stock is an equity security conveying a residual ownership claim on a company: holders rank behind creditors and preferred shareholders in liquidation, normally vote on corporate matters, and receive dividends only if and when the board declares them..
Cost of EquityCost of equity is the rate of return shareholders require for holding a company's shares, given the risk they bear.
Dividend YieldDividend yield is annual dividend per share divided by the current market price per share, expressing the cash income a shareholder receives as a percentage of the price paid.
PerpetuityA perpetuity is a stream of identical cash flows that continues indefinitely with no maturity date.

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Preferred Stock

Compare with common stock, which holds the residual claim and the voting power.