The term “perpetual” refers to preferred shares that have no expiration date and a dividend payment guarantee upon issuance. Let’s take a look at perpetual preferred stocks and determine what investors need to know before buying any of these shares.
What is Perpetual Preferred Stock?
The holders of perpetual preferred shares will continue to receive a set dividend payment for as long as the company remains active. In most circumstances, it is redeemable before to maturity, although there is no specified deadline for redemption.
Unless redeemed, dividends on issued perpetual preferred shares will continue to be paid so long as the issuer continues. These shares, like ordinary stock, are exchanged on stock exchanges.
Understanding Perpetual Preferred Stock
Permanent or nonpermanent preferred stock may be issued. Investors in perpetual preferred stock will continue to receive the same dividend payment regardless of how long it takes the issuing company to go out of business.
However, the company retains the right to repurchase the shares at any time, subject to the terms mentioned in the prospectus. This repurchase clause is comparable to the conventional bond market call clause.
Changes in interest rates and tax law are two of the most frequent reasons why firms repurchase perpetual preferred shares from investors. Remember that if you lose your shares as a result of a redemption, you will also lose your income source.
For example, if the dividend yield on the company’s preferred stock falls below the dividend yield paid to shareholders, the company will likely repurchase the existing perpetual preferred stock.
The capacity of investors to reinvest their cash at the same dividend rate, which had been so useful in producing a steady stream of income, would be compromised.
A perpetual preferred stock is similar to a bond with an extremely long maturity date, but there are significant distinctions.
How Perpetual Preferred Stocks Work
Typically, perpetual preferred stock is redeemable by the issuer. In the case of retractable perpetual preferred stock shares, the issuer has the ability to recall the shares.
Shareholders may choose between receiving cash or common stock in exchange for par-value shares (the value set at the time of issuance for redemption purposes).
Capital One, for example, will notify owners of its perpetual preferred shares of a significant change in 2020. They were informed of “a quarterly dividend on outstanding shares of its 6.00% Fixed Rate Non-Cumulative Perpetual Preferred Stock, Series B” (the “Series B Preferred Stock”).
Each existing share of Series B Preferred Stock is represented by a depositary share reflecting a 1/40th interest in a share of Series B Preferred Stock.
The dividend distribution on March 2, 2020 to shareholders of record on February 14, 2020 will be $15.00 per share (or $0.375 per depositary share outstanding).
Types of Perpetual Preferred Stock
There are several varieties of perpetual preferred stock, including:
This perpetual preferred stock has a faster profit growth rate than the market average. Consequently, investors acquire growing firms with the prospect of price appreciation rather than dividends. There are growth stocks available at many technology companies.
Investing in income stocks is ideal if you desire a stable monthly income. Income stocks are popular with investors due to their consistent dividend distributions. An example of a company likely to have income stocks is an established utility.
Value stocks are more inexpensive than growth stocks due to their lower PE ratios. The stocks of companies with a low P/E ratio can be either growth or income stocks, however they may be less desirable to investors.
Investors purchase value stocks with the belief that the market has overreacted and that the stock’s price will rebound.
The phrase “blue-chip stock” refers to the shares of large, well-established organizations as opposed to those of smaller, riskier companies.
These stocks are the most desired by investors due to their constant profitability and inclusion in important indexes and stock market benchmarks, such as the New York Stock Exchange, the S&P 500, and the Nasdaq 100.
The Walt Disney Company (NYSE: DIS), Apple Inc. (NASDAQ: AAPL), and The Coca-Cola Company (NYSE: KO) are examples of blue-chip companies (NASDAQ: AAPL).
Pricing Perpetual Preferred Shares
The dividends on perpetual preferred stock must be paid in perpetuity since the stock itself can exist in perpetuity. Therefore, the value of such assets is determined by the present value (PV) of a perpetuity, which is the fixed dividend amount divided by the dividend yield.
Perpetual Preferred Stock Price = Fixed Dividend ÷ Dividend Yield
The issuer of nonperpetual preferred shares will typically establish a buyback price and date at least 30 years after the date of issuance. In addition, it has a distinct termination date, which increases the predictability of money flows.
Preferred Stock vs. Bonds
Preferred stock is attractive to investors because it combines the liquidity of stocks with the safety of fixed income. Preferred investors occupy a higher position in the corporate structure than regular stockholders.
This advantage is significant not just in the case of insolvency, but also for dividend payments and voluntary asset liquidations.
When a company is liquidating its assets to pay its creditors, preferred shareholders receive precedence. In this instance, preferred stocks offer greater security than common stocks.
On the other hand, preferred investors do not immediately share in the company’s earnings. These stockholders are only entitled to receive the dividend rate that was in force when they purchased their shares.
Buying preferred shares with a $10 yearly dividend would be an illustration of an investment. A year later, the company raised the annual dividend to $15. The dividends paid to preferred investors are $10, whereas the dividends paid to common stockholders are larger.
A firm may issue bonds or preferred shares for a variety of reasons. Prior to acquiring either, it is essential to ascertain whether or not the company’s balance sheet is already burdened with debt.
There is a potential that you may be penalized by credit agencies or get in problems with the police if you incur further debt. Individuals cannot deduct their preferred stock investments, unlike corporations. However, preferred stock yields are frequently higher than equivalent bonds.
Before investing in preferred stock, you should consider the potential drawbacks. Even though it may come as a surprise to some, many companies with lower credit ratings sell preferred stock. In the event that the board of directors decides to temporarily cease dividend payments, preferred investors have few options.
Alternatives to Perpetual Preferred Stock
If you are interested in receiving consistent payments, preferred securities, which are fixed-income assets issued by big insurance companies and banks that pay dividends, are an alternative to perpetual preferred shares.
Preferred stock is a long-term investment that is subject to early redemption at any moment (can be paid off earlier than the maturity date). They share characteristics with both stocks and bonds and may potentially offer higher returns than common stock or corporate bonds.
Pros and Cons of Perpetual Preferred Stock
- Receive dividend payments before common stockholders: Dividends paid to holders of perpetual preferred shares are paid prior to dividends paid to holders of common stock.
- Have priority over common stockholders if the company goes bankrupt: In the case of bankruptcy, permanent preferred stockholders will be compensated before common stockholders.
- Preferred stockholders do not typically have voting rights: This entails being denied the right to vote in company elections.
What It Means for Individual Investors
Investors in perpetual preferred stock should be informed that they will receive priority payments from the sale of their shares in the event of the company’s bankruptcy and subsequent liquidation of its assets. Bondholders get compensation before preferred shareholders.
How Do You Determine a Perpetual Preferred Stock Valuation?
Those who are contemplating investing in a new firm want to know its value. Additionally, the founder must be aware with these data for the capitalization table, often known as a cap table, which lists the individual investors’ common and preferred shareholdings as well as the sums they paid for them.
Similar considerations apply when assessing and pricing perpetual preferred shares.
Calculating the Price of Preferred Stock
Let’s begin by examining how much preferred stock truly costs. Then, we will focus specifically on perpetual preferred shares.
According to the Corporate Finance Institute, the cost of preferred stock for a corporation is the price paid by the company in return for the profits made by selling the shares.
It is the annual dividend distribution divided by the one-time capital injection the company got when it issued the stock.
Founders should use the following calculation to determine the cost of preferred stock:
Rp (cost of preferred stock) = D (preferred stock dividend) / P (preferred stock price)
To see this formula in action, consider the following illustration. Imagine that a new corporation is issuing preferred shares with an annual dividend of $5. If the price of common stock is now $20, the price of preferred stock is computed as follows:
Rp = 5 / 20 = 25%
Let’s determine the cost of preferred stock with a dividend yield. The equation applicable here is:
Rp (cost of preferred stock with growth) = DY1(preferred stock dividend at year 1) / P (preferred stock price) + Growth rate
As an example, the Corporate Finance Institute utilizes a 2% growth rate and a $3 dividend distribution, so let’s examine this situation. If the current stock price is $21, the price of preferred stock is calculated as follows:
Rp = 3 / 21 + 2% = 16.57%
Considering that preferred stock calculations are growing increasingly sophisticated, it is advised to utilize a specialized application.
Calculating the Price of Perpetual Preferred Stock
Since perpetual preferred stock recognizes shares indefinitely, dividends will be paid into the foreseeable future as long as the firm is in operation, giving investors with a considerable incentive.
In conclusion, the formula for perpetual preferred stock is “the fixed dividend amount divided by the discount rate.” Consequently, the formula may be expressed as follows:
Perpetual preferred stock price = fixed dividend amount / dividend yield
Here is an example:
Let’s say an investor in your company buys 100 shares of preferred stock that pays a $4 dividend every year. The dividend yield for this investment, which costs $50 per share, is 8%. You paid exactly $50, which is the current value of $4 when multiplied by 0.08.
What Is Cumulative Perpetual Preferred Stock?
Let’s go a step further and break this down. When a company issues cumulative perpetual preferred stock, what does that mean?
“Cumulative perpetual preferred stock” is a type of preferred stock that has a clause that says dividends must be paid to holders of cumulative perpetual preferred stock first if dividends were missed in the past for whatever reason.
Let’s look at what could happen if this does happen. If a startup is having trouble making money, it may temporarily stop paying dividends. Once these money worries are taken care of, the new business may want to start paying dividends again.
If the company has issued cumulative perpetual preferred stock, the dividend payments that have been delayed or put on hold must be paid to the holders of that stock first.
We will talk about whether or not other preferred or ordinary shareholders can get dividend payments that were not paid on time in the next section.
Here’s a more in-depth example of what was said above:
Let’s say a business pays 6% in dividends every year on cumulative preferred stock worth $10,000. Because of this, the new company should give its preferred investors $600 in dividends each year.
When a pandemic hits the whole world, all business stops right away. In this case, the young business would not be able to pay dividends. As the economy continues to fall behind by one calendar year, there are no dividends paid for a full two years.
The economy gets better the following year, and the young company starts paying dividends again.
Dividends on preferred stock from the past two years are still due. If the company doesn’t pay dividends on cumulative preferred stock for two years, the investor is entitled to $600 for each share kept.
So, for every cumulative preferred share they own, each of these stockholders owes cumulative preferred stockholders $1,200. If this doesn’t happen, the dividends of the other shareholders won’t be paid out.
What Is Non-Cumulative Perpetual Preferred Stock?
Non-cumulative perpetual preferred stock is a no-pay option when it comes to dividends. Because of this, non-cumulative perpetual preferred investors do not get dividend arrears if dividends are not paid or are missed in some other way.
That is, if the company decides not to pay dividends one year, those shareholders will never be able to get any dividends that haven’t been paid yet.
Instead of non-cumulative perpetual preferred stock, investors should think about buying cumulative perpetual preferred stock.
Shares of perpetual preferred stock do not have an expiration date. To put it another way, the investor will have the right to redeem the shares as long as they keep them in their possession.
So, as long as the shareholder keeps the shares in the investment, he or she will keep getting dividends. Stocks like these are usually stable and give regular returns without a lot of risk, so investors who want to play it safe usually keep at least a few of them.
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