Mastering Preferred Dividends: A Comprehensive Guide


Preferred dividends are a crucial component of corporate finance, offering investors a steady income stream while influencing a company’s financial strategy. This comprehensive guide dives deep into preferred dividends, covering their various facets, benefits, drawbacks, and implications for both investors and businesses.

Understanding preferred dividends

Preferred dividends are a key element in the intricate web of corporate finance, impacting both investors and businesses. To comprehend their significance fully, let’s delve deeper into the world of preferred dividends.

What is a preferred dividend?

Preferred dividends represent a financial reward allocated to holders of a company’s preferred shares. These dividends possess a unique characteristic that sets them apart from common dividends: precedence. In the event that a company encounters financial challenges and cannot meet all its dividend obligations, preferred dividends take priority. This distinctive feature makes preferred dividends a significant consideration for both investors and businesses.

Exploring Preferred Dividends

Preferred dividends are not just a financial term; they shape the financial landscape of companies. These dividends hold the power to influence financial strategies and investment decisions, and their management falls under the jurisdiction of a company’s board of directors.

Preferred dividends are not susceptible to whims or market fluctuations. They are determined based on the par value and dividend rate specified in the preferred stock prospectus. However, this fixed nature can have its downsides, particularly during periods of high inflation when the real value of these dividends may erode due to a lack of adjustments for inflation.

Companies diligently plan for preferred dividends, and these payments are typically set in advance. They carry the privilege of precedence over common stock dividends. Whether they are a fixed percentage or linked to benchmark interest rates, most companies distribute preferred dividends on a quarterly or annual basis.

Calculating Preferred Dividends

Calculating preferred dividends involves a straightforward formula. The equity’s dividend rate and par value are explicitly mentioned in the preferred stock prospectus. To determine the total annual preferred dividend, simply multiply the dividend rate by the par value. If these dividends are paid in installments, such as quarterly, the total is divided equally among the payment periods.

Companies assess their financial health through a critical metric known as the preferred dividend coverage ratio. This ratio serves as a litmus test for a company’s ability to meet its preferred stock dividend obligations. A higher coverage ratio implies greater financial stability and reassures preferred shareholders that their dividends will be honored.

Dividends in Arrears

Companies sometimes opt to defer dividend payments, a strategic decision made based on various factors. However, it’s essential to understand that preferred stockholders hold a unique position in the dividend hierarchy. Any unpaid preferred dividends accumulate as obligations that must be settled before common stockholders receive their dividends. These accumulated obligations are known as dividends in arrears. Clearing these arrears is a prerequisite before current-year dividends are disbursed.

It’s worth noting that not all preferred stock operates this way. Noncumulative preferred stock lacks the feature of accumulating omitted dividends, making them less favorable for income-focused investors.

Additional Preferred Dividend Features

Preferred stockholders enjoy preferential treatment when it comes to dividends. In exchange for this privilege, they may not partake in earnings exceeding fixed dividend amounts. While some preferred stock may offer participation rights, the majority are nonparticipating.

Callable preferred stock is an interesting variant. It tends to yield higher preferred dividends, but it comes with a trade-off. Investors accept the risk of early redemption by the issuing company, sacrificing long-term security for potentially greater immediate income.

On the contrary, convertible preferred stock typically offers lower preferred dividends. However, it sweetens the deal by providing investors with the option to convert their preferred stock into common stock, potentially benefiting from capital gains.


Here is a list of the benefits and drawbacks to consider.

  • Preferred dividends offer a dependable income stream for investors, enhancing financial security.
  • Preferred stockholders have priority in receiving dividends over common stockholders, ensuring a consistent income source.
  • Some preferred stocks feature higher dividend rates compared to common stocks, attracting income-focused investors seeking higher yields.
  • Companies declaring preferred dividends demonstrate financial stability, assuring investors and creditors of their sound financial health.
  • Fixed preferred dividends may not adjust for inflation, potentially eroding their real value over time.
  • Callable preferred stocks can lead to early redemption, which may disrupt long-term income plans for investors.
  • Convertible preferred stocks offer lower dividend rates in exchange for conversion options, potentially affecting immediate income.
  • Noncumulative preferred stockholders may lose out on omitted dividends, making them less favorable for income-seeking investors.

Frequently asked questions

Can preferred dividends ever be adjusted?

No, preferred dividends are typically fixed and do not change over time. They are based on the par value and dividend rate specified at the time of issuance.

Are preferred dividends taxable?

Yes, preferred dividends are generally subject to taxation as ordinary income. The specific tax rate depends on the individual’s overall income and tax bracket.

Do all companies issue preferred stock?

No, not all companies issue preferred stock. The decision to issue preferred stock depends on the company’s financial strategy and capital needs. It’s more common among larger, established companies.

What is the role of preferred dividends in a company’s financial stability?

Preferred dividends play a vital role in demonstrating a company’s financial stability. Consistently paying preferred dividends can signal to investors and creditors that the company is in good financial health, enhancing its reputation and access to capital.

How do callable preferred stocks affect preferred dividends?

Callable preferred stocks may result in higher preferred dividends due to the associated risks. Investors accept the possibility of early redemption by the issuing company, which often comes with a premium. This can impact long-term income plans for investors, but it offers the potential for immediate income gains.

Key takeaways

  • Preferred dividends provide a dependable income stream for investors and take precedence over common dividends, enhancing financial security.
  • Calculating preferred dividends involves multiplying the dividend rate by the par value of the stock, a simple yet essential calculation for both investors and businesses.
  • Dividends in arrears represent unpaid preferred dividends that must be settled before common shareholders receive any dividends, emphasizing the priority of preferred stockholders.
  • Convertible preferred stocks offer the option to convert into common stock, potentially affecting dividend rates and providing flexibility for investors.
  • Not all companies issue preferred stock, and the decision depends on their financial strategy and capital needs.
View Article Sources
  1. Cumulative preferred dividends from capital surplus – Maine Legislature
  2. Reducing Rate of Dividend on Preferred Stock – Notre Dame Law Review
  3. preferred dividend – Cornell Law School
  4. A Beginner’s Guide to Shares: Investing in the Stock Market – SuperMoney