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Preferred Stock

( Originally Published 1939 )

IT is generally believed that preferred stock always has preference over common as to both earnings and assets, but in some instances this is not strictly true. For that reason, the investor, buying preferred stock, should ascertain what he is buying. For in-stance, a preferred stock may be preferred only as to earnings, and in the event of dissolution, it shares equally with common. Such cases are isolated; nevertheless, it takes only a moment to ascertain the true status of the stock.

It is also necessary to know whether there is more than one issue of preferred outstanding, and what issue you are buying. If, for instance, the Compass Motor Company has an "A" and "B" series of preferred outstanding, the "A" series comes before the "B" series in its preference over the assets and earnings, just as it does over common, or just as a first mortgage bond takes preference over a debenture.

The majority of preferred dividend-paying stocks are cumulative, and must be paid before anything can be paid to common stock, nevertheless, that clause does not necessarily insure its payment. The company can reduce its dividend payment or suspend it entirely. On the other hand, they can pay it in whole or in part, from surplus. Therefore, simply because you are receiving your preferred dividends, don't jump to the conclusion that they are earned. Examine the statements and find out.

Some authorities state that the dividends on preferred should always be earned at least 3 times over, and while this may be a safe barometer, I personally would prefer to use a measuring rod of 4 1/2 to 5. And this does not apply to any specific year. It should show this for at least a five-year average. Some companies earn six, seven, eight and even ten times their preferred dividend requirement. However, a great deal depends on the capital structure. Some companies preferred may be in greater proportion to common than others, that is, one company may be capitalized at one million common and five hundred thousand preferred, while another company in the same industry may be capitalized at one million common and only two hundred and fifty thousand preferred.

Hence, if the latter company reflects preferred dividend requirements ten times over, and the former company only five times, it doesn't mean that the latter company is doing more business and earning more money. It does mean, however, that the latter company's preferred obligation is only one-half as much as the first mentioned company, and the dividends are much more assured.

There is another form of preferred stock which should be mentioned, and that is participating preferred. As a rule, participating preferred means that after its dividend has been paid, and a similar amount paid to common, it will then participate with common in the distribution of further dividends.

For instance, the Compass Motor Company's preferred stock is known as seven percent participating preferred. After the preferred has received $7.00 per share, and the common has received $7.00 per share, any remaining amount to be declared must be divided pro rata per share for both common and preferred.

On the other hand, some companies may have their participating preferred on a percentage, after the regular dividend has been paid. That is, a certain percent of the earnings is set aside for preferred, after its regular dividend has been paid. In most companies which employ this method of participating preferred, the amount set aside for further distribution usually averages around ten percent of what is available for common. The payment of participating dividends, however, depends entirely upon earnings.

Many preferred stocks carry a conversion privilege, that is, at the option of the holder, they can be converted into common stock of the company. The rate of conversion is stipulated in individual stocks. Conversion becomes attractive when the company shows large earnings on its common, which in turn influences the market price of the common upward.

For example, if the Compass Motor Company's seven percent preferred stock is selling at $105.00 per share, and is convertible share and share alike into its common, which is paying eight per-cent and selling at $110.00 per share, it is obvious that it would be to the investor's advantage to exchange a share of preferred stock, selling at $105.00, for one of common selling for $110.00. On the other hand, if the market price of the common fell to $105.00, even though it was paying a little higher dividend, it might be unwise to convert.

I have noticed that many investors are of the opinion that preferred stock does not vote. In some instances this is true, but there are many variations of this rule. Some companies' preferred stock carries a greater voting power than its common; at times as much as four or five to one. Other companies provide that when a certain number _of dividends have been passed, the preferred stockholders can then exercise the right to step in and vote, even to the extent of receiving exclusive voting power. In such instances the preferred stockholders have a direct voice in the election of new directors and management.

Just as bonds are callable and retirable often times prior to maturity, preferred stock may also be redeemed at the option of the company. Usually a specific price is named at which the stock can be called and redeemed, and also the notice necessary to the stockholders. Some companies provide for its calling on any dividend date, others give thirty to ninety days notice, and still others can call on demand.

The clause providing for the calling of the stock is not necessarily beneficial to the stockholders. It is at the option of the company to call it, and certainly they won't call it, if it is to their disadvantage.

Suppose, for instance, the seven percent preferred stock of the Compass Motor Company was callable at the option of the company at $115.00 per share. Notwithstanding that the affairs of the company may be such as to justify the stock selling at $120.00 in a rising market, with its common booming, nevertheless, the retirable feature of $115.00 may prevent it from going higher. Thus, as far as market appreciation is concerned, there is no advantage, or at least not much, in preferred. Any stock which is callable at the company's option will necessarily be to the company's advantage when it is called, and not to the stockholders.

In the contemplation of preferred stocks, the investor must calculate the yield. The stock is seldom selling at par. It is either above or below. Naturally, to find the yield you would necessarily divide the dividend into the price paid for the stock. If, for example, the Compass Motor Company's preferred is selling at $80.00 per share, and their dividend is $7.00 per share, the stock purchased is then yielding over eleven percent. Usually, however, the smaller the dividend, the greater the security.

The investor in preferred stock usually purchases his stock, in preference to bonds, for any number of reasons, but namely, a higher yield, a preference over common, a voice in the management at times, possibly a participating dividend, and a possible conversion feature.

The investor who contemplates preferred stock, however, has a number of things to analyze and determine. The dividend per share must be considered, and than the yield based on its current selling price. If this proves attractive, then its position as to both dividends and assets must be determined. Its cumulative provision is also very important, and equally as vital is whether or not it is participating. Having established that, then determine what voting power, if any, is attached to it.

This enumerates the most vital things to determine in considering preferred stock, although it is always the part of wisdom to consider the callable features and the conversion privileges.

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