What Are Preferred Dividends?
Preferred dividends are payments made by companies to holders of preferred shares, a unique class of equity that traditionally provides shareholders with benefits not available to common shareholders. If a company does not have sufficient net income to cover all its dividends, the obligations owed to preferred shareholders are prioritized over those owed to common shareholders, which adds a layer of security for preferred stock investors.
Key Takeaways
- Definition: Preferred dividends are cash distributions specifically allocated to a company's preferred shareholders.
- Higher Returns: Generally, preferred stocks provide higher dividend rates than common stocks, making them attractive to income-focused investors.
- Fixed Obligations: Companies declare their future preferred dividend obligations ahead of time and must reserve funds to meet these commitments, particularly if they accumulate in arrears.
- Order of Payment: Preferred dividends must be paid from net income before any dividends can be disbursed to common shareholders.
How Preferred Dividends Work
The allocation of dividends is the responsibility of a company’s board of directors, which assesses the company’s profitability and determines whether to issue dividends, the amount, and their frequency. Preferred dividends are unique in that their rates are typically predetermined, based on a percentage of the stock's par value. This contrasts with common dividends that can fluctuate depending on a company's performance and strategy.
Calculation of Preferred Dividends
To determine the annual preferred dividend, one would multiply the par value of the preferred shares by the predetermined dividend rate:
[ \text{Total Annual Preferred Dividend} = \text{Dividend Rate} \times \text{Par Value} ]
If dividends are payable in portions (quarterly or annually), this total amount is divided accordingly to find the periodic payment.
Preferred Dividend Coverage Ratio
The preferred dividend coverage ratio is a critical metric that assesses a company's ability to pay its preferred dividends. Calculated as follows:
[ \text{Preferred Dividend Coverage Ratio} = \frac{\text{Net Income Available to Preferred Shareholders}}{\text{Total Preferred Dividends}} ]
A higher ratio signals stronger financial health and capability to service preferred share obligations, enhancing investor confidence.
Dividends in Arrears: What It Means
One notable aspect of preferred dividends is the provision for dividends in arrears. If a company chooses to suspend or forgo dividend payments, the accrued amounts do not simply disappear; they accumulate and legally obligate the company to pay preferred shareholders before any payments can be made to common shareholders.
Cumulative vs. Non-Cumulative Preferred Stock
- Cumulative Preferred Stock: If dividends are missed, they accrue and must be paid later, granting preferred shareholders a safeguard against missed payments.
- Non-Cumulative Preferred Stock: These types of shares do not accumulate unpaid dividends, meaning missed payments are not owed in the future.
Additional Features of Preferred Dividends
Preferred stocks may come with certain features that affect their attractiveness and the dividends they pay:
- Callable Preferred Stock: This can be redeemed by the issuing company before its maturity date, often providing higher dividends as investors assume additional risk with the potential for early redemption.
- Convertible Preferred Stock: Allows shareholders to convert their shares into common stock, typically with lower dividends due to the added option for equity conversion.
Benefits and Raw Trade-offs
While preferred shares are an appealing investment for those seeking stable income through dividends, they often come with trade-offs. Preferred shareholders typically give up voting rights associated with common shares and may have limited growth potential since they do not participate in earnings exceeding set dividends significantly.
Conclusion
Preferred dividends serve as a vital component of preferred stock investment, providing stability and consistent income for shareholders. Understanding the nature of these dividends, how they are calculated, and their implications in terms of company obligations is crucial for investors looking to incorporate preferred shares into their portfolio. As the financial landscape evolves, being informed about such investment vehicles can empower shareholders to make more strategic financial decisions.