Evaluating Convertible Preferred Stock

Investors are effectively purchasing a share of ownership that gives them a higher claim on earnings and assets than common stockholders. So preferred stockholders receive dividends before common stockholders, and if the company goes into liquidation, they receive priority (but are behind bank and trade creditors). Preferred stock is eventually exchanged for a fixed number of common shares. As there is no stated maturity date, the value of preferred stock is calculated on the basis of dividend yield, or as a percentage of par value.

Common stockholders receive high dividends when the company is doing well, and low dividends (or none at all) when it's doing badly. Preferred stockholders are entitled to fixed dividend payments, which accumulate if they cannot be paid. However, in general they have no voting rights, while common stockholders have rights in relation to the number of shares they own.

"Callable" preferred stocks are those that the issuing company can buy back, usually at par value (or slightly higher). An "indirect convertible" may be exchanged for another convertible security—for example, bonds in exchange for convertible preferred stock. Holders of "participating preferred stocks" are entitled to additional dividends (along with common stockholders), as well as specified dividends.

Stockholders who decide to turn down their conversion rights may have the right to cash instead. Interest rates on preferred stock tend to be lower than that of other fixed-interest securities, because the stockholder has the chance to convert the investment into common stock (and make a profit if the price has risen above the conversion price). Sometimes issuing companies are required to redeem preferred stocks after a given period, giving investors a small profit.

Should a company go into liquidation, venture capitalists will be high on the list to receive any proceeds. In addition, if they convert their shares into common stock at the agreed time and rate, they gain the right to vote on key issues like who sits on the company board, or developments in relation to central business functions.

Among mature companies in particular, this is a valid concern. However, an issue of preferred stocks may still benefit assertive companies with good track records—and their investors—especially if profit margins can be maintained or increased. Investors should watch out for an anti-dilution provision in the conversion formula, designed to protect their holdings when subsequent stock is sold off more cheaply. It's important to check exactly what protection is on offer—for example, the greater the safeguard on convertible preferred stock, the more likely common stock is to be diluted.

Assessing common preferred stock requires research, an understanding of the market and an evaluation of performance—as with any other investment. Firstly, investors should identify how a company makes its profits, and decide whether it can meet its obligations to preferred stockholders. Tools available to help form such judgments include preferred stock ratings and ratios like EBIT or EBITDA (earnings before interest, taxes, depreciation, and amortization). The latter is typically used to assess how well a company can meet interest payments on loans, but can be adapted as follows to measure preferred stock dividends:

The higher the ratio, the better.

Investors can also consult rating services, like Moody or Standard & Poor. They're all slightly different, but essentially follow the pattern ABC…where AAA is the best and D means "in default." Anything below B ("investment grade") is considered risky. Note that if the only source of ratings is a less prominent service, it suggests that major services were not prepared to make a judgment. Also, take care if you can't find ratings on company Web sites or through their investor relations departments.

Below are basic guidelines for assessing preferred stocks.

• Preferred stocks should have a higher yield (annual dividend divided by price) than the issuing company's comparable debt. Yield should be judged case-by-case.
• Other essential markers are conversion ratios and prices, which should be available on stock indenture statements. Sometimes the statements indicate that ratios will change after certain periods (e.g. increase by $x every x years).
• If there's a stock split, this can also have an effect.
• Some investors think that convertible exchangeable preferred stock tends to be issued by the less successful companies, while the better performers opt for standard convertible preferred stock.
• Others contend that it's a mark of excellence when a company can issue straight debt cost-effectively, while middle ranking companies issue convertible securities, and the least successful go for additional common stock.

Although most convertible preferred stocks are supposed to have permanent status, in practice they are generally converted within a decade—either forcibly or voluntarily (perhaps induced by a steady rise in common stock dividend payments). Therefore, the features of preferred stock conversions are similar to those of debt securities—in which investors are protected against a call for about three years, and are given about 30–60 days' notice when it does occur. Having said that, about half the issues of convertible equities include a "soft call provision," which states that if common stock reaches a certain ratio, the issuing company can force a conversion, even within the normal period of protection.

• Tax law in the U.S. means that companies must provide a prospectus with issues of common and preferred stock. It must address points such as: whether dividends are cumulative; if shares can be redeemed (when, and how likely?); have dividends ever been suspended (if so, it could indicate cash flow difficulties)?
• The cost of issuing preferred stock can be offputting, and dividends are paid out of profits after tax. Bond dividends on the other hand are paid before tax, which makes them more attractive to issuing companies.
• Owning preferred stock is altogether different, since corporations can take up to 80% of dividend income free of tax.
• If the issuing company misses preferred stock dividend payments, it's not considered tax evasion. However, it may result in common stock dividends not being paid either, and preferred stockholders gaining seats on the board or even special voting rights. Also, in most cases dividends accrue—so when the company resumes payment they must pay off all the cumulative preferred stock dividends before they can pay the common ones.
• If a company goes into liquidation, preferred stockholders can get back the value of their investment before common stockholders get anything at all. This means the original amount invested, plus any unpaid dividends that have accrued. So for the investor, there are safeguards however the company performs. If it does well, preferred stocks can be converted into common stock. If not, the investor at least gets the agreed rate of interest and the chance to recover their investment if necessary.

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