Understanding Preferred Dividends
A preferred dividend is a payout that is allocated specifically to holders of a company’s preferred shares. When a company cannot meet all of its dividend obligations, claims to preferred dividends take precedence over claims to dividends on common shares.
Key Takeaways
- Exclusive Rewards: Preferred dividends refer to the cash rewards given to preferred shareholders, often at a higher rate than common stock dividends.
- Higher Rates: Preferred stock usually provides higher dividend rates compared to the same company’s common stock.
- Pre-determined: Companies announce their obligations to preferred shareholders in advance, ensuring fund allocation for these payments.
- Priority Payments: Preferred dividends are paid from net income before any considerations for common share dividends.
From Decision to Distribution: The Mechanism of Preferred Dividends
Company boards decide whether, and how much, dividends will be distributed to common stockholders, treating it as a profit-sharing incentive. They can adjust these decisions based on financial performance and strategic priorities.
Preferred dividends follow the par value and the fixed dividend rate of the preferred stock, providing consistent, although static, payouts. While steady, this reliability can be a disadvantage during times of high inflation since payment rates are unadjusted.
Preferential dividends are paid out before any other dividends, calculated through predetermined percentages or tied to benchmark interest rates. This characteristic ensures regular payouts, typically on a quarterly or annual basis.
Formula and Calculation
The calculation for preferred dividends hinges on the equity’s dividend rate and par value, outlined in the preferred stock’s prospectus. To calculate the annual preferred dividend:
$\text{Dividend Rate} \times \text{Par Value} = \text{Total Annual Preferred Dividend}$
If payouts happen in smaller periods, divide the total annual dividend by the number of periods:
$\frac{\text{Total Preferred Dividend}}{\text{Number of Periods}}$
Evaluate a company’s ability to meet its preferred dividend obligations through the preferred dividend coverage ratio, a critical indicator of fiscal health ensuring dividend payments are secure.
Handling Dividends in Arrears
When a company skips dividend payments, preferred shareholders’ rights take precedence, mandating that missed payments accumulate. These arrears become required payouts before any dividends to common shareholders. Noncumulative preferred stock differs in that unpaid dividends are not accumulated.
Pending dividends must be transparently displayed in the company’s financial statements, ensuring these obligations are clear.
Additional Features to Understand
Preferred stockholders gain preferential treatment in dividends, generally at the cost of sharing surplus earnings. Specific types of preferred stock may offer the right of participation, liberating dividends from fixed interest constraints, though most issuances remain non-participating.
Callable preferred stock offers higher dividends as compensation for the associated risk of early redemption. If retired at a call price, subsequent dividends may be included in the repurchase agreement.
Convertible preferred stock provides lower dividends, offering the perk of conversion into common stock, blending flexibility, and value prospects for investors.
Leverage this insight to navigate the prioritization and management of dividends within your investment portfolio or corporate finance strategy.
Related Terms: dividend yield, dividend cover, common stock, equity, callable preferred stock.
