Cumulative Preferred Stock
Cumulative Preferred Stock: Definition, Features, and How It Works
Definition
Cumulative Preferred Stock is a type of preferred stock that provides shareholders with a guarantee that any unpaid dividends will accumulate and must be paid before common stockholders can receive dividends. In other words, if a company is unable to pay dividends to cumulative preferred stockholders in one year, the dividends owed accumulate and must be paid in subsequent years before any dividends are distributed to common shareholders.
Cumulative preferred stock is considered a more favorable investment option than non-cumulative preferred stock because it offers a layer of protection for investors. In the event of financial hardship or an underperforming year, cumulative preferred shareholders still have a claim to any missed or deferred dividend payments.
Key Features of Cumulative Preferred Stock
Dividend Priority:
Cumulative preferred stockholders have a higher priority than common shareholders when it comes to receiving dividends. This means they must be paid first, even if the company has limited funds for distribution.Dividend Accumulation:
If the company cannot pay the full dividend in any given year, the unpaid dividends accumulate and are carried forward. These unpaid dividends must be cleared before any dividends are paid to common stockholders.Fixed Dividend:
Cumulative preferred stock usually comes with a fixed dividend rate, which is a predetermined percentage of the stock's par value. For example, a cumulative preferred stock with a par value of $100 and a fixed dividend rate of 5% would pay $5 annually to shareholders.Callable Feature:
Like many preferred stocks, cumulative preferred stock may be callable, meaning the company can choose to repurchase the stock at a predetermined price after a specified period.No Voting Rights:
Cumulative preferred stockholders generally do not have voting rights in the company, unlike common stockholders. However, some companies may grant voting rights under special circumstances, such as when dividends are in arrears for a certain period.
How Cumulative Preferred Stock Works
Here’s an example to illustrate how cumulative preferred stock functions:
Let’s assume Company ABC issues cumulative preferred stock with the following characteristics:
Par Value: $100
Annual Dividend Rate: 5%
Total Outstanding Shares: 1,000 shares
In the first year, Company ABC experiences a financial downturn and decides to pay no dividends. In this case, the cumulative preferred stockholders are entitled to receive the unpaid dividends in the following year. So, if the company is able to pay dividends in the second year, it must first pay the accumulated dividend from Year 1 before paying any dividend for Year 2.
Year 1 (Dividend Missed):
Dividend Owed: $5 per share (5% of $100 par value)
Total Unpaid Dividend for Year 1: $5,000 (1,000 shares × $5)
Year 2 (Dividend Paid):
Dividend Owed for Year 2: $5 per share
Total Dividend Owed for Year 2: $5,000
Total Dividend Due to Cumulative Preferred Stockholders in Year 2: $10,000 (Year 1 + Year 2)
In Year 2, before any dividends are distributed to common stockholders, the $5,000 owed from Year 1 must be paid first. Only after this payment can the company distribute the Year 2 dividends.
Advantages of Cumulative Preferred Stock
Dividend Protection:
Cumulative preferred stockholders are protected in case the company faces financial difficulties and cannot pay dividends in a particular year. The dividends accumulate and must be paid before common stockholders receive any payments.Priority in Dividend Distribution:
In the event that the company decides to distribute dividends, cumulative preferred stockholders will always be paid first. This gives them a better chance of receiving their dividends compared to common stockholders.Predictable Income:
Investors in cumulative preferred stock can expect a consistent and predictable income stream, provided the company pays the accumulated dividends. This can make cumulative preferred stock an attractive option for income-seeking investors, such as retirees.Potential for Capital Appreciation:
Although cumulative preferred stock doesn’t typically offer voting rights, its fixed dividend and the priority status in dividend payments make it less risky than common stock, while still providing potential for capital appreciation if the company performs well.
Disadvantages of Cumulative Preferred Stock
No Voting Rights:
Unlike common stockholders, cumulative preferred stockholders typically do not have the ability to vote on important company decisions, such as mergers, acquisitions, or electing board members. This means they have no say in the company’s strategic direction.Limited Upside Potential:
Cumulative preferred stock usually comes with a fixed dividend and limited capital appreciation. If the company performs exceptionally well, common stockholders may benefit more from the increase in stock price, while preferred stockholders’ returns remain capped at the fixed dividend.Callable Feature:
Many cumulative preferred stocks are callable, which means the company can repurchase the shares at a predetermined price. If the company calls the preferred stock, investors may lose the opportunity for further dividend payments.Interest Rate Sensitivity:
Cumulative preferred stock can be sensitive to interest rate changes. If interest rates rise, the fixed dividend on preferred stocks may become less attractive to investors, leading to a potential decline in the market value of the stock.
When to Consider Investing in Cumulative Preferred Stock
Cumulative preferred stock can be an attractive investment for those who are looking for a steady income stream, particularly in industries that are less volatile. It may be especially appealing to conservative investors, such as retirees, who seek less risk and a predictable return on investment.
It’s also a good option for investors looking for lower risk compared to common stocks, as preferred stockholders have a higher claim to dividends and assets in the event of liquidation. However, due to the lack of voting rights and limited potential for capital gains, those seeking higher growth or more involvement in company decisions may not find cumulative preferred stock to be suitable.
Conclusion
Cumulative Preferred Stock provides a secure and predictable income stream for investors, with the added benefit of accumulating dividends if they are not paid in a given year. It prioritizes dividend payments over common stock, offering a layer of protection for investors. While it may not provide the same level of growth potential as common stock, it is an attractive option for income-focused investors seeking stability.
Before investing in cumulative preferred stock, it’s important to consider your financial goals, risk tolerance, and the overall health and stability of the issuing company. Understanding the rights and limitations of this investment type will help ensure it aligns with your broader investment strategy.
Key Takeaways
Cumulative preferred stock offers guaranteed dividends that accumulate if unpaid in a given year.
It has a higher priority over common stock for dividend payments, making it a safer option for income-seeking investors.
While it provides stable returns, it lacks voting rights and offers limited upside potential compared to common stock.