The reasons to buy preferred stock

3 min read

Preferred Stock Explained

Shares of preferred stock express an ownership stake in some company. It is like a share of common stock but less volatile.
But there are more advantages by holding preferred stocks. For example, they are prioritized when it comes to dividends or bankruptcy. But by owning this stock you will not have the same voting rights as owner of common stock. Actually, you will not have them.

Preferred stock is similar to bonds. See, with preferred shares, you will have a fixed dividend in continuity. And you can easily calculate the dividend yield. All you have to do is to divide an amount of dividend in the currency by the current price of the stock. Yield is the effective interest rate you earn when you buy a share of the preferred stock.  

Let’s do some math.

Assume a preferred stock has an annual dividend of  $6 per share and is trading at $120 per share. So, the yield is $6 divided by $120 which is 0.05. Multiply by 100 to turn to the percentage. The yield is 5%.

6/120 = 0.05

0.05 x 100 = 5

This is regularly based on the standard value ere a preferred stock is sold. It’s generally determined as a percentage of the current market price after the trade starts. This is a difference from a common stock. Common stock has variable dividends that are published by the board of directors and it is never guaranteed. Moreover, a lot of companies don’t pay out to common stocks. 

The added difference is that this kind of stocks has a par value. It is in correlation with the interest rate. If the interest rate increases, the value of preferred stock drops. Also, when the interest rate decreases, the value of this stock will grow. You will not find a similar situation with common stock since its value is determined by supply and demand in the market

Why buy preferred stock?

Investors frequently buy preferred stock for the income the dividends give. The dividends for them are higher than those issued for common stock. And the other benefit is notable. If the company has to miss out a dividend it collects, it still must pay preferred stock dividends before any common stock dividends come to the schedule. That is why they carry less risk than common stock. Preferred stock owners must be paid before common stockholders if the company failed or in case of bankruptcy.

When evaluating the investment potential of preferred stock, it is most important to compare the dividend yield to the yields of the company’s bonds. You will find that preferred stocks often work similarly to bonds.

Preferred stock is a good choice for investors who don’t want to take a big risk. Moreover, it is less volatile than common stock and provides a better flow of dividends.

One thing more is present here.

Those stocks give more options to investors. Let’s explain this.

Numerous preferred shares are callable. This means the issuer can purchase them at any time. Investors have a true chance for these shares to be called back at a redemption rate. It can be a notable bonus over their purchase price. The market for preferred shares usually assumes callbacks and prices may be bid up respectively.

And we pointed out that one disadvantage. Its shareholders regularly do not have voting rights as the owners of common stock. It may be a problem for some investors.

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