The preferred stock formula is used to calculate how much an investor will pay to purchase the stock and how much they get as dividends for the preferred stock they have acquired. The formula which tells the investor how much they will spend is expressed as the preferred stock dividend divided by the preferred stock price while the other one that tells the investor how much they get as dividends is expressed as par value multiplied by the rate of dividend multiplied by the number of stocks.

Below, we will look at the preferred stock formula, definition, calculation examples, types, characteristics, differences between preferred stock and common stock, pros, and cons as well as some frequently asked questions on preferred stock.

Preferred stock definition

Broadly speaking, preferred stock is a type of stock. It is a share capital component that is generally considered a hybrid instrument because it has properties of both equity and debt instrument. It is considered equity because it can appreciate in price and as a debt instrument, it pays its holders fixed dividends regularly.

In simple terms, preferred stockholders receive preferential treatment – get paid dividends first – in a situation where the company in which they hold the stock is going through any of the following:

1. Voluntary bankruptcy: when the company is unable to repay its debts and starts a legal process to seek relief from some or all of its debts.
2. Involuntary bankruptcy: when the company creditors start a legal process requesting the company to declare bankruptcy.
3. Mergers: when two existing companies come together on equal grounds to become one new company.
4. Acquisition: as the name implies, this is simply when a company buys another company. This could be done by buying most or all of the shares of that company.
5. Voluntary liquidation: when the company distributes its assets to pay debts so as to shut down permanently.
6. Involuntary liquidation: When the court orders the company to cease operation permanently so as to use its assets to repay debts.

Preferred stock usually comprises a small portion of the shares issued by a company, this is because it often comes with a minimum purchase amount which makes it more expensive than common stocks. Most companies issue them as a means to fund developmental or expansion projects.

Preferred stock is also known as preference shares (in Britain and Australia) or preferreds or preferred shares. They are considered hybrid assets that lie between stocks and bonds. Preferred stock holders are paid dividends regularly either monthly or quarterly depending on the terms of the stock.

Preferred stock formula

Before investing in any company, most investors want to find out what they will gain when they buy preferred stock from a company as well as how much they are going to spend; this is where the preferred stock formula comes in. The preferred stock formula tells the investor how much they will spend to purchase the stock and the dividends the company will pay them for their investment.

The preferred stock formula which tells the investor how much they will spend to purchase the stocks is known as the stock price formula while the one which tells the investor how much dividends they will receive is known as the preferred dividends formula.

Calculating preference shares using the stock price formula

The stock price formula which tells the investor how much it will cost them to buy the preferred stock is expressed as dividend for preferred stock divided by the rate of return for preferred stock

Calculating preference stocks using the preferred dividends formula

The type of preferred stock formula that tells the investor the dividends they will receive multiplies the par value of the preferred stock with its rate of dividend and the number of preferred stocks owned by the investor.

Examples

The preferred stock formula is of no use on its own if its parameters are not inserted to make a calculation. Therefore, using the preferred stock formula, we will look at some calculation examples below.

Example 1

Suppose a company issues 10% preferreds with a face value of $1000 and a market return rate of 8%, we can calculate the price of the preferreds using the formula below

Stock price = Dividend for preferred stock ÷ Rate of return for preferred stock

however,

Dividend for preferred stock = Dividend rate x Par value

Rate of return for preferred stock = Market return rate

Therefore we can rewrite the formula to find the stock price as

Stock price = [(Dividend rate x Par value) ÷ Rate of return for preferred stock]

Stock price = [(10% x $1000) ÷ 8%] = $1,250

This means that any investor who wants to buy the stock will spend $1,250

Example 2

Assuming a preference share has an 11% rate of return, a dividend rate of 5%, and a face value of $100, its price can be calculated as

Stock price = [(Dividend rate x Par value) ÷ Rate of return for preferred stock]

Dividend rate = 5%

Par value = Face value = $100

Rate of return = 11%

Stock price = [(5% x $100) ÷ 11%] = $45.45

This means that any investor who wants to buy the stock will spend $45.45

Example 3

Suppose a company issued 10,000 preferred stocks and Miss. A owns 2,000 of these. If they were issued at $20 per stock at 3% dividend rate, we can calculate what she is expected to get as dividends using the preferred dividend formula:

Preferred dividend = Par value x Rate of dividend x Number of preferred stock

Par value = $20

Rate of dividend = 3% ÷ 100 = 0.03

Number of preferred stock = 2,000

Preferred dividend = 2,000

Preferred formula = $20 x 0.03 x 2,000 = $1,200

This means that Miss. B will recieve $1,200 annually as dividends.

Example 4

Suppose an investor owns 10,000 preferred shares in a company. If the preferred shares have dividends of 8% per value of stock and the market value of each stock is $80. The expected dividends of the investor can be calculated as

Preferred dividend = Par value x Rate of dividend x Number of preferred stock

Par value = Market value = $80

Rate of dividend = 8% ÷ 100 = 0.08

Number of preferred shares = 10,000

Preferred dividends = $80 x 0.08 x 10,000 = $6,400

This means the investor will recieve $6,400 annually as dividends.

Preference stock types

1. Cumulative preference shares.
2. Noncumulative preferred stock.
3. Preference preferred stock.
4. Prior preference shares.
5. Convertible preference shares.
6. Perpetual preferred stock.
7. Exchangeable preference shares.
8. Putable preferred stock.
9. Participating preference shares.
10. Monthly income preferred stock (MIPS)

Preferreds have different types as listed above based on some peculiar characteristics that differentiate them. Below we will have a brief look at each of these Preferreds types.

Cumulative

The cumulative preference shares as the name implies have a cumulative dividend payment policy, this means that whenever dividend payments are skipped for whatsoever reason, they accumulate and must be paid in the future.

Noncumulative

With these types of preferreds, the issuing company is not obligated to repay any omitted or unpaid dividends because the dividends do not accumulate. This means that any unpaid dividends are not paid in the future.

Preference

These shares get preference compared to the other types of preferred shares when it comes to dividend payments with only the prior preferred stock ranking higher. This means that when a company is paying dividends after it has paid those holding prior preferred stock, the next investors that get paid are the preference preferred shareholders.

Prior

The prior preferred stockholders receive priority over all other preferred stockholders when it comes to dividend payments. This means that even though all preferred stockholders get paid before common stockholders, holders of prior preferreds get paid first before the other types of preferred stockholders.

Convertible

These are stocks that can be converted into a certain number of the company’s common stock. Investors should however note that once the convertible preferred stock has been converted into a common stock, it cannot be converted back into a preferred stock again. According to Wikipedia, Variants of this type of preferred stock have been developed by investment banker Stan Medley. It is known as the anti-dilutive convertible preferred.

Perpetual

The perpetual preference shares have no specific maturity or buyback date. This means that for as long as the company that issues it is in business, the investor will receive a fixed dividend either quarterly or yearly hence its name; perpetual.

Exchangeable

The exchangeable preferred share is one that can be exchanged for any of the different types of security owned by the issuing company.

Putable

This type of share gives its holder the option of selling back the share to the issuing company at an already predetermined date. As a result of this, the putable preferred share is said to have a put option.

Participating

Participating preferred stockholders receive a participating dividend aside from the regular dividends paid to other types of preferred stock. For example, if the issuing company makes more profit than was expected, investors with this type of stock get paid extra dividends from the profit.

Monthly income preferred stock (MIPS)

The monthly income preferred stock (MIPS) is so named because it provides its holders with monthly dividends. This type of preferred is said to be a mixture of preferred stock and subordinated debt. It is issued by a special purpose entity (SPE) created by a parent company to issue stock on their behalf. The special purpose entity that issues the stock does so with the intention of lending back the proceeds to the parent company. The intricate nature of this type of stock provides the parent company with a tax deduction and investors with higher monthly dividends.

Preferred shares characteristics

1. Preference dividend payment.
2. Redeemable.
3. Convertible to common stock.
4. Preference during liquidation or bankruptcy.
5. Higher dividends.
6. Nonvoting.
7. Mixed instrument.
8. Fixed dividend.

In the list above, some basic characteristics of preferred stocks are captured. These characteristics may differ from one preferred to another based on their type. Some preference shares may have more or less of the characteristics too because the issuing company may decide to add or remove from them in their shares prospectus.

We will have a brief look at these preference shares characteristics below:

Preference dividend payment

Unlike other shareholders, holders of preferred shares get paid first (shown preference) when dividends are paid, and in an event when a company is struggling financially and unable to pay dividends, preferred stockholders will still get paid first when dividend payments resume. If the preferred shares are cumulative, they get paid arrears dividends as well.

Redeemable

Preferred stocks can be redeemed before the maturity date for an already determined amount known as the call price. The issuing company can also choose to repurchase the stock from the holders, this is commonly known as callability. Callable stocks are usually purchased back by the issuer at par value. If however, the issuing company does not call the stock and the investor does not redeem their stocks, the stocks will continue to trade on the stock exchange.

Convertible to common stock

Preferreds can be converted to common stocks. The particular type that has this feature is the convertible preferred stock. Depending on the terms in the stock prospectus, stock conversion can be initiated by the investor or the issuing company or the stock might convert automatically after the stipulated date.

Preference during liquidation or bankruptcy

As in the case of dividends payment, preferred stockholders also receive preference in cases of liquidation or bankruptcy. Holders of preferred shares have a claim to a company’s assets if it liquidates or goes bankrupt and have a greater claim on being repaid previously unpaid dividends. Their claim is usually equal to the market value of their stock unless otherwise stated in the stock prospectus.

Higher dividends

Another key feature of preferred stocks is that they get paid higher dividends than other stock types which adds to why some investors prefer purchasing them instead of the other stock types. This is also why companies issue them in limited numbers.

Nonvoting

Most preferred stocks are nonvoting, which means that their holders cannot vote on anything in the company, however, based on the rights assigned to some preferred stocks at the time of incorporation, they may come along with voting rights. The voting rights are usually for one-off events such as electing the company’s board of directors or the approval of buying a company or merging with another company. Additionally, some preferred shareholders get the right to vote if they have not received dividends for a specified period.

Mixed instrument

Preferred shares are mixed instruments because they combine characteristics of both equity and debt instrument. They are considered equity because they can appreciate in price and as a debt instrument, its holders get paid fixed dividends regularly. The fixed dividend payment makes preferred stock a predictable income source which makes them rated by major credit rating agencies.

Fixed dividend

Preferred stocks have a fixed amount paid as dividends to their holders. This amount is usually stated as a percentage of the fixed par value of the stock. In rare cases, some preferred stocks might not have a fixed dividend amount, instead, their dividends may change following industry benchmarks; these are known as floating dividends.

Pros of preference shares

1. Retention of control.
2. Variety of stock types.
3. Source of capital.
4. Financial burden reduction.
5. Reduces expenses.
6. Source of income.

Preferred stocks have pros that benefit either the issuing company or the stockholder, below, we will have a look at these pros.

Retention of control

Since preferred stockholders do not have voting rights in the issuing company, the company owners have 100 percent control over the company neven after issuing preferred shares.

Variety of stock types

The different types of preferred stock provide a variety of options both for the investor and the issuing company.

Source of capital

Preferred shares serve as a source of capital for the issuing company as funds raised through the sales can be used for business expansion or the purchase of equipment.

Financial burden reduction

The fact that the issuing company can pay preferred stockholders in arrears – in the case of cumulative preferred stocks – or not at all for the other preferred stockholders, it can serve as a means of reducing the company’s financial burden.

Reduces expenses

The payment of fixed dividends serves as a means of saving money for the issuing company since they do not have to pay stockholders more than the stipulated dividends even when they have higher profits.

Source of income

The payment of fixed dividends serves as a means of predictable income to the stockholders especially since they always get paid before other shareholders.

Cons of preferred stock

1. Lack of industry diversity.
2. No voting rights.
3. No equity growth.

Like every other type of investment, preferred stock has some cons too. We will look at some of these below:

Lack of industry diversity

Preferred stocks have no industry diversity as they are mostly issued by companies in the financial sector such as banks. The few other companies that issue this type of shares are startups looking to raise funds without jeopardizing their company’s core values through issuing shares with voting rights.

No voting rights

Preferred shareholders have no say in the companies they have shares in since most preferred shares do not have voting rights attached to owning them.

No equity growth

Preferreds have no equity growth. Since preferred stockholders receive fixed dividends, they have no increase in income even when the company has a huge profit.

Differences between preferred stock and common stock

Preferred stock is a share capital component which is a hybrid instrument. Common stock is a type of security that represents ownership in a company. Since these two types of stock are the most widely known, we will look at some differences between them below:

Preferred stock	Common stock
Has multiple types	Has only one type
No voting rights	Have voting rights
Get paid dividends first before common stockholders.	Get paid dividends after preferred stockholders.
Can be converted to common stocks.	Cannot be converted to preferred stocks.
It is a mixed instrument; equity and debt.	It is a single instrument; equity.

FAQs on preferred stock

Conclusion

Preferreds are beneficial both to the issuing company and the investor as they serve as a means of raising funds for the issuing company and a source of steady income for the investor. The variety in types also aids both investors and companies to better decide which particular preference share type is best suited to them.

Companies may combine any number of characteristics in the preferreds they issue so long as they do not break any regulations guiding the issuance of shares. Investors seeking to buy the preferred stock should check the offering terms contained in the prospectus of the stocks to have a better understanding of the stocks they are purchasing and what benefits it offers to them.