Preferred Dividend

Preferred Dividends: Definition and Overview

Preferred dividends are payments made to holders of a company’s preferred stock. They generally:

• Have a fixed rate set at issuance.
• Take priority over dividends on common stock — preferred shareholders are paid first.
• Are typically paid quarterly or annually.
• Offer more stable income than common-stock dividends but usually do not rise with company earnings or inflation.

How Preferred Dividends Work

The company’s board specifies the preferred stock’s dividend rate and par value in the offering prospectus. The dividend can be a fixed percentage of par value or tied to a benchmark interest rate. Because preferred dividends are determined in advance, companies must allocate funds to meet those obligations before paying common shareholders.

Calculating Preferred Dividends

The basic calculation is:

Annual preferred dividend = par value × dividend rate

If dividends are distributed periodically, the issuer divides the annual amount by the number of payment periods (e.g., 4 for quarterly).

The preferred dividend coverage ratio gauges a company’s ability to pay preferred dividends. A higher ratio indicates a stronger ability to meet those payments.

Dividends in Arrears (Cumulative vs. Noncumulative)

Preferred stock can be cumulative or noncumulative:

• Cumulative preferred stock: Missed dividends accumulate as “dividends in arrears” and must be paid before any dividends are paid to common shareholders. These arrears are recorded in the company’s financial statements.
• Noncumulative preferred stock: Missed dividends do not accumulate and can be permanently forgone.

Dividends in arrears can delay or reduce distributions to common shareholders and indicate financial stress at the company.

Additional Features and Their Impact

Preferred shares may include features that affect dividend levels and investor trade-offs:

• Participating preferred: May receive additional dividends beyond the fixed rate when common shareholders get extra distributions.
• Callable preferred: The issuer can redeem the shares at a predetermined call price. Because this exposes investors to early repurchase risk, callable issues often pay higher dividend rates.
• Convertible preferred: Can be converted into common shares. The potential upside of conversion typically results in a lower fixed dividend rate.

Benefits and Drawbacks

Benefits
* Priority over common dividends increases income security.
* Generally higher dividend rates than the company’s common stock.

Drawbacks
* Fixed payments do not adjust for inflation or improved company performance.
* Limited participation in upside earnings and capital appreciation compared with common stock.

Key Points

• Preferred dividends are fixed and paid before common-stock dividends.
• Annual dividend = par value × dividend rate; periodic payments are the annual amount divided by the number of periods.
• Cumulative preferred shares create dividends in arrears if payments are skipped; noncumulative do not.
• Features such as participating, callable, and convertible alter dividend rates and investor risk/return profiles.

Conclusion

Preferred dividends provide a middle ground between debt and common equity: more stable income and priority over common dividends, but less growth potential and inflation protection. Investors should review the preferred stock’s terms (rate, par value, cumulative status, and special features) and assess the issuer’s dividend coverage before investing.