Finance 101: What Exactly Is Preferred Stock?
Finance 251

Finance 101: What Exactly Is Preferred Stock?

Finance 101: What Exactly Is Preferred Stock?

When you buy stock in a company, you are essentially buying ownership of a very small portion of that company. If you were to think of any major company, there is a good chance that the ownership of the company is split up into stocks. For example, you could go onto a public stock exchange and buy one common stock of Coca Cola. This share would increase and decrease in value, depending on how well the business does. 

There are two main types of stock: preferred stock and common stock. In the vast majority of stock deals, common stock is the type of stock issued. When you look up the stock price of a certain company, the result will always be the value of the common stock, not the preferred stock.

Typically, the founders/leadership of a company will take a large portion of their paycheck in company stock so that they are motivated to make the business do well. This is also pretty much always done in common stock. The reason for this is that the price of common stock will increase and decrease according to the market, whereas the price of preferred stock will always be the same.

So, what exactly is preferred stock then? If the value of it stays the same, how can it be tied to the company? There are often stories of institutional investors’ investments in preferred stock like this here, but what does it really mean? These questions and more will be answered in this article, as we go over the characteristics of preferred stock and how it differs from common stock.

What Makes Up Preferred Stock

Preferred stock is typically viewed as more of a bond than a risk investment. Meaning, it is expected that the money you put into preferred stock will be more stable than if it were to be put into common stock. The result is a price that neither goes up when the business is doing well, nor does it go down when the business is doing poorly. Additionally, the price of preferred stock is typically set by the dividends that the company can pay to the owners of the preferred stock.

Most companies will pay an equivalent dividend to their common stock and preferred stockholders, while some will pay extra dividends to the preferred stockholders. Owners of preferred stock will also enjoy a prioritized payment from the company, as preferred stock is, well, preferred. 

In addition to this, if a company is struggling financially and has to halt the payment of dividends to its shareholders, the preferred shareholders may be given additional dividends before the payment of dividends to common stockholders may resume.

In the event that a company has to completely close and decides to liquidate, preferred stockholders get priority for any assets that could go toward giving them 100 cents on the dollar (which, in most cases, does not happen). Unfortunately, while the stockholders do have priority over common stockholders, they do not have priority over the internal revenue service nor the creditors and employees. When it’s time for the preferred stockholders to pick at what’s left, they often do not get a complete return on their investment.

With that said, it is much more than the common stockholders get in a case of liquidation (which is all but certainly zero). A good example of this is the Enron collapse, or more recently the collapse of Chinese company Evergrande.

Who Buys Preferred Stock?

As mentioned in the example in the beginning of the article, preferred stock is often purchased by institutional investors looking to invest a large amount of capital into another company. 

While the price of the individual preferred share may not increase that much over the lifespan of a company, the dividend yields may. This could result in some decent gains for large institutional investors that buy preferred stock early on in a company.

We hope this article was able to give you a clear understanding of what preferred stock is, and how it differs from common stock or bonds. Whether you plan to purchase preferred stock yourself or not, it is a great word to have in your financial vocabulary.

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Finance 251