22. What is Preferred Stock Video Lecture | Become an Expert: Value Investing - Business Basics

welcome the course to unit 4 lesson 1
what is a preferred share in this lesson
we're going to learn about what a
preferred share is and then we're going
to learn what are the things to consider
when purchasing a preferred share so
let's get started okay so for a lot of
people they don't really know what a
preferred share is they've heard of it
but they really don't understand how it
works so that's what we're going to
cover in this unit and in this lesson
specifically we're just going to go
through the fundamentals of a preferred
share so when you look at this chart you
can see that the lowest risk that you're
going to have on any investment is a
bond when you're dealing with stocks or
bonds the preferred share is actually
right in the middle on the risk and then
the common share which we've talked
about up to this point in the previous
units and lessons has all been common
shares so a preferred share is actually
kind of in the middle as far as actually
owning some of the equity of the
business but the preferred share
performs like a bond so as we go in the
next slide you're going to kind of see
how that works but as far as the thing
that you got to really understand as far
as risk is that the preferred share
isn't as risky as owning common shares
but it is definitely more risky than
just owning the bond of a company one of
the unique things about a preferred
shares a lot of people would think that
it would operate and have a lot of the
same fundamentals as a common share but
it actually operates a lot more like a
bond so whenever you buy a preferred
share it's instead of having a coupon
it's going to have a dividend of
preferred share is a proportional piece
of equity in a business now what will
confuse a lot of people is your piece of
that business your equity of that
business is only going to come about if
the company would liquidy so that
proportional ownership that you own of
that business really isn't doing
anything for you as proof as far as like
the the market price of that preferred
share changing unless that company would
liquidate that's whenever the whatever's
left if not all the money would go to
the bondholders whatever money would be
left would then be paid to the preferred
shareholders and then any money that be
left over after both the bond holder and
the preferred shareholder would
pay would then go to the common
shareholders and so that situation in my
personal opinion is very unlikely if you
go through a liquidation of bankruptcy
for a business pretty much the
bondholders are the only ones that are
going to be able to get anything that
remains in the business so that that
share of equity that you're actually
getting with a preferred share in my
opinion really isn't worth anything
because nine times out of ten if a
company would go bankrupt and liquidate
all that money's and be gone to the
blonde holders and the preferred
shareholders and the common shareholders
are pretty much going to lose everything
at that point so how does a preferred
share work as you can see here on the
left hand side I have a bond okay and
it's we're just going to call this
company X so one bond of company X we're
going to say that the term on the bond
is thirty years and if this terminology
isn't making sense for you I strongly
encourage you to go back to course one
unit two in order to take the the three
lessons about bonds and all this will be
crystal clear after you take those
lessons so go back and take a look at
those if these terms aren't making sense
for you but let's say on the left hand
side we have a bond
the term is 30 years the face value is
$1,000 and the coupon is 50 bucks so our
yield we know based off of those figures
would give us a 5% yield on that bond so
just like that
we have one preferred share of company X
okay and let's just say that the term on
that preferred share is 30 years the
face value instead of it being a
thousand is only 25 dollars and it pays
an annual dividend of a dollar and fifty
cents a year and so when you would take
that dividend and divide it by the face
value
you'd get actually a six percent yield
so this preferred share is very much
like the bond in that it has a term it
has a face value instead of a coupon
it's now a dividend the nice thing about
to prefer chair is it's a cheaper price
than the thousand dollars for the face
value on the bond but it's operating
exactly through the same fundamentals
now a lot of preferred shares don't have
a term now a lot of preferred shares
don't have a term of thirty years or ten
years
their perpetual intern so this scenario
is kind of a unique one you're not going
to see that real common it's much more
common to see a perpetual preferred
share meaning that they'll issue it and
it's out there until they decide to
terminate the preferred share by buying
it back so but you can't find preferred
shares with with term limits on them so
how does it work so the first thing that
you have to understand whenever you're
buying a preferred share is that you
have to read the certificate of
designation and that certificate of
designation describes all the
intricacies of how that preferred share
works and operates so like I said before
this one that we used for company X has
a term of actually 30 years and then the
company is going to go ahead and buy
that preferred share back from the
holder but that's not always the case so
as you look at one company's preferred
share to the next it can be completely
different the way that it operates and
all of that information is found in this
certificate of designation so if you're
interested in purchasing preferred
shares this is something that you're
definitely going to have to become
familiar with and understand before you
just kind of dive into something like
this then you got to understand that
preferred shares are not a real big
market you're you've got a lot more
bonds on the market a lot more common
shares on the market than you'll ever
find in the preferred share market so
you really to understand how a preferred
share works you really got to understand
why a company would want to issue a
preferred share okay so if just kind of
picture yourself as being the CEO of a
large business and a lot of the times
you'll see preferred shares issued on
newly IPO type companies they're just
going public that really need to raise
some money and so the beauty of a
preferred share from the CEOs
perspective and from the shareholders
perspective that currently on the
company is that they can raise a lot of
money by issuing these preferred shares
okay and they have the flexibility set
up that that certificate of designation
they can actually have the the verbage
in there so that they can delay their
dividend payments even though that they
they say they're going to make a fixed
dividend payment of let's say six
percent they can actually delay that and
let those dividend payments
accumulate and then pay them later some
some certificates of designation will
actually have verbage in there that you
don't even that the company doesn't even
have to repay the dividend it's just
really kind of goodwill to the person
who purchases it so that's why you
really need to read that certificate in
order to understand how that verbage is
that if you were the company issuing
these preferred shares that's a great
thing because now you have the
flexibility to not even make that that
dividend payment to the person who's
holding it so that gives the company a
lot of flexibility also this is the real
reason and it's because the company can
retain its equity of the business for
those common shareholders so think of it
this way if you're a common shareholder
of a business and you want to raise some
money but you don't want to give up that
equity that you currently possess up the
business issue some preferred shares
because although that person thinks
they've got some equity of the business
the only time that that equity is going
to be materialized as if the company
would liquidate or fail so let's say you
issued a 6% preferred chair out of your
company to raise some money and interest
rates go down to like 4% and they're
much lower well you'll obviously want to
pay off that holder of that preferred
chair which you would have that set up
in your indenture so that you can do
that so you pay off that preferred chair
issue new ones at the lower interest
rate so you're not paying such a high
interest rate to the holder and so you
have that flexibility to immediately pay
off that preferred share and all that
equity immediately disappears whenever
you buy that preferred chair back
so really the equity they sure that
you're seeing you're not seeing any
growth in a market price or anything
like that because the market price is
going to be completely dependent on the
interest rate alone just like a bond
just like you saw with a bond so what's
some of the things that you might see in
this certificate of designation so the
first thing that I want to bring up is
the cumulative preferred versus a non
cumulative preferred so a cumulative
preferred you'll eventually get your
dividend but you might not have the
ability to compound a consistent
dividend payment but at least you're
getting that payment so in this scenario
here where the dividends at all are
fifty four company X
um if the company can't make the payment
and they skip that payment that dividend
payment they eventually have to make
that payment they have to pay you the
dollar 50 so maybe your next dividend is
$3.00 as opposed to just a dollar 50
because they have to make that up
now whenever you see terminology in this
certificate of designation for a
non-cumulative preferred that company
does not have to pay you the dividend
they're most likely gonna pay the
dividend but they don't have to and
that's something that you got to really
be ware of I would never ever buy a
preferred share with a non-cumulative
preferred dividend payment okay so I
briefly talked about the term and how
many preferred shares are perpetual
preferred shares and it has an open no
maturity date to it
so that company can issue that preferred
share and it can stay out there for as
long as they want and they can just keep
making those payments to you so if you
buy a preferred share and has a very low
interest rate you might be holding on to
that for a really long time and
unfortunately for that person who would
buy a low interest yielding preferred
share because it has no term to it it's
not going to then rise back up to that
face value of 25 dollars for this
generic share we have here it might just
sit down there at $15 so you might buy
that preferred chair for $25 and
interest rates start rising from where
you bought it it might sit down there in
a market price of $15 forever as you
continue to hold it because there's no
exit strategy for this type of person
that that bought a preferred share
without a term so there's two learning
points there either
make sure you buy one that has a term or
make sure you don't buy a preferred
share with a really low interest rate
and you avoid that scenario okay so the
next thing that you got to be aware of
is the call ability of the preferred
chair you're pretty much always going to
find preferred chairs with a call
ability clause and the certificate of
designation so that's just something
that you're going to have to work with
few a few buy a preferred share with a
really high yield let's say you're
buying something at 10% or 8% and it's a
fairly decent company they don't have
you know enormous amounts of debt you
can pretty much expect that to get
called
so when you buy that you just kind of
kind of go into that with the
anticipation that you're going to be
called on that and they're going to pay
back your initial purchase price or the
face value of the preferred share in
order to get there in order to stop
paying at high interest rate so that's
just something you got to be ready for
most preferred shares have an adjustable
dividend rate now I told you that it was
a fixed dividend rate at the beginning
of the lesson but depending on how that
certificate of designation set up you
might actually purchase a preferred
share that has an adjustable dividend
rate this is something that you want to
avoid unless it's unless you're buying a
low interest rate because then it'll
probably go up for you but you know the
name of the game and as you guys have
learned up to this point is you want to
when you're buying a fixed income
security or a preferred share you're
trying to find something paying a high
dividend you're trying to get something
that whenever those yield curves are
pretty flat and above your 4 and 5
percent mark for your 10-year federal
note you're wanting to find something
that has a high yield and that is fixed
because that's what gives you the
leverage for whenever the interest rates
drop to sell that at a nice premium so
then you can use that to go and buy your
common shares so just something to think
about something that you're going to
definitely want to look for if you're
going to buy and preferred shares that
you want to try to avoid something that
has an adjustable dividend rate so just
to kind of quickly recap here what we're
looking for when we're purchasing a
preferred share one you absolutely have
to read that certificate of designation
and understand all those basic
fundamentals that I just discussed you
definitely want to buy a cumulative
preferred share because that's gonna
guarantee that you're going to go ahead
and get that dividend payment you want
to avoid if possible perpetual terms
because that's gonna allow you to have
an exit strategy that's going to allow
you to have the market price eventually
go back to the face value of what the
preferred share was issued at and you're
just going to have to beware of callable
securities so that concludes course to
unit 4 lesson 1 what is a preferred
share so in this lesson we learned what
a preferred share was and we learned
what are the things that to consider
when purchasing a preferred
so I hope this lesson was helpful and
I'll see you guys in the next lesson