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“The course to unit. 4 lesson. 1. What is a preferred share in this lesson.
Lesson. We re going to learn about what a preferred share is and then we 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 1000. 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. 300. 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 ” ..
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