You will need to understand preferred stock for the Series 7 exam. Equity securities represent shares of ownership in a company, and debt securities represent debt. Preferred stock is an equity security because it represents ownership of the issuing corporation the same way that common stock does.
Characteristics of preferred stock
One advantage of purchasing preferred stock is that shareholders receive money back before common stockholders do if the issuer declares bankruptcy. However, the main difference between preferred stock and common stock has to do with dividends. Issuers of common stock pay a cash dividend only if the company’s in a position to share corporate profits.
By contrast, issuers of preferred stock are required to pay consistent cash dividends. Preferred stock generally has a par value of $100 per share and tends to trade in the market somewhere close to that par value.
Some of the drawbacks of investing in preferred stock are lack of voting rights, the higher cost per share, and limited growth. You can assume for Series 7 exam purposes that preferred stockholders don’t receive voting rights unless they fail to receive their dividends. Also, because the price of preferred stock remains relatively stable, preferred stockholders may miss out on potential gains.
To calculate the annual dividend, multiply the percentage of the dividend by the par value. For instance, if a customer owns a preferred stock that pays an 8 percent dividend and the par value is $100, you set up the following equation:
If the issuer were to pay this dividend quarterly (once every three months), an investor would receive $2 every three months.
When working on a dividend question on preferred stock, you need to look for the par value in the problem. It’s normally $100, but it could be $25, $50, and so on.
Types of preferred stock
You need to be aware of several types of preferred stock for the Series 7. Here are the distinctions between noncumulative and cumulative preferred stock:
Noncumulative (straight) preferred: This type is rare. The main feature of preferred stock is that investors receive a consistent cash dividend. In the event that the issuer doesn’t pay the dividend, the company usually still owes it to investors. If the preferred stock is noncumulative and the issuer fails to pay a dividend, the issuer doesn’t owe it to investors.
Cumulative preferred: Cumulative preferred stock is more common. If an investor owns cumulative preferred stock and doesn’t receive an expected dividend, the issuer still owes that dividend. If the issuer declares a common dividend, the issuer first has to make up all delinquent payments to cumulative preferred stockholders.
The following question tests your understanding of cumulative preferred stock.
An investor owns ABC 8 percent cumulative preferred stock ($100 par). In the first year, ABC paid $6 in dividends. In the second year, it paid $4 in dividends. If a common dividend is declared the following year, how much must the preferred shareholders receive?
(A) $6
(B) $8
(C) $12
(D) $14
The right answer is Choice (D). Because ABC is cumulative preferred stock, issuers have to catch up preferred stockholders on all outstanding dividends before common shareholders receive a dividend.
In this example, the investor is supposed to receive $8 per year in dividends (8% × $100 par). In the first year, the issuer shorted the investor $2; in the second year, $4. The investor hasn’t yet received payment for the following year, so she is owed $8. Add up these debts:
All preferred stock has to be either cumulative or noncumulative.
Convertible preferred: Convertible preferred stock allows investors to trade their preferred stock for common stock of the same company at any time. Because the issuers are providing investors with another way to make money, investors usually receive a lower dividend payment than with regular preferred stock.
The conversion price is the dollar price at which a convertible preferred stock par value can be exchanged into a share of common stock. When the convertible preferred stock is first issued, the conversion price is specified and is based on par value. The conversion ratio tells you the number of shares of common stock that an investor receives for converting one share of preferred stock.
You can use the following conversion ratio formula for convertible preferred stock and also for convertible bonds:
Callable preferred: Callable preferred stock allows the issuer to buy back the preferred stock at any time at a price on the certificate. This stock is a little riskier for investors because they don’t have control over how long they can hold the stock, so corporations usually pay a higher dividend on callable preferred stock.
Participating preferred: Although rarely issued, participating preferred stock allows the investors to receive common dividends in addition to the usual preferred dividends.
Prior (senior) preferred: Preferred stockholders receive compensation before common stockholders in the event of corporate bankruptcy. In this case, senior preferred stockholders receive compensation even before other preferred stockholders. Because of the extra safety factor, senior preferred stock pays a slightly lower dividend than other preferred stock from the same issuer.
Adjustable (floating rate) preferred: Holders of adjustable preferred stock receive a dividend that’s reset every six months to match movements in the prevailing interest rates. Because the dividend adjusts to changing interest rates, the stock price remains more stable.
The following example gives you an idea of how to determine the conversion ratio.
If ABC preferred stock ($100 par) is convertible into common stock for $25, what is the conversion ratio?
(A) 1 share
(B) 4 shares
(C) 25 shares
(D) 100 shares
The answer you want is Choice (B). This equation is about as simple as the math gets on the Series 7 exam. Because the $100 par value preferred stock is convertible into common stock for $25, it’s convertible into four shares:
