What is Cumulative Preferred Stock?

Cumulative preferred stock is a special kind of stock that some companies offer. It’s different from regular stock, which is also called common stock.

How is it Different from Common Stock?

When you buy a share of common stock, it means you own a tiny piece of the company. If the company makes money, you might get some of the profit. This is called a dividend. But the company doesn’t have to pay a dividend if it doesn’t want to or if it can’t afford to.

Preferred stock is different. If you own preferred stock, the company promises to pay you a dividend before they pay dividends to people who own common stock. They might say something like “We will pay preferred stockholders $1 per share before we pay anyone else.” This $1 is just an example – the real amount can be different for each company.

What Makes Cumulative Preferred Stock Special?

Now, cumulative preferred stock is even more special than regular preferred stock. Here’s why:

Let’s say the company promises to pay preferred stockholders $1 per share each year. But one year, the company has a bad year and can’t afford to pay the $1. If you own regular preferred stock, you just miss out on that $1. The company doesn’t owe you anything extra the next year.

But if you own cumulative preferred stock, the company keeps track of the money they owe you. If they miss a year, they have to pay you that missed $1 later, before they can pay any dividends to common stockholders.

How Cumulative Dividends Work

Imagine a company that has cumulative preferred stock. They promise to pay $1 per share each year. Here’s what might happen over a few years:

• Year 1: The company pays you $1 per share, just like they promised. Everything is good.
• Year 2: The company has a tough year. They can’t afford to pay any dividends. If you owned regular preferred stock, you would just miss out on the $1 for that year. But because you own cumulative preferred stock, the company now owes you $1.
• Year 3: Things are still tough. The company again can’t pay dividends. Now they owe you $2 (the $1 from year 2 and the $1 from year 3).
• Year 4: The company is doing better. They have enough money to pay dividends again. Before they can pay anything to common stockholders, they have to pay you the $2 they owe from the last two years. Plus, they have to pay you the $1 for the current year. So you get $3 per share.
• Year 5 and on: If the company continues doing well, you’ll get your regular $1 per year, and common stockholders can start getting dividends too.

This is a simple example, but it shows how cumulative preferred stock protects investors. You might have to wait longer to get your money, but the company can’t just skip payments forever. They have to pay you what they owe before they can pay others.

Comparison to Noncumulative Preferred Stock

Noncumulative preferred stock is the other main type of preferred stock. It’s in between common stock and cumulative preferred stock.

Like cumulative preferred stock, owners of noncumulative preferred stock are promised a certain dividend per share, and they get paid before common stockholders.

However, like common stock, if the company misses a dividend payment one year, noncumulative preferred stockholders don’t get that money later. The company doesn’t accumulate the missed dividends like they do with cumulative preferred stock.

Why Companies Offer Cumulative Preferred Stock

You might be wondering why a company would offer cumulative preferred stock. After all, it seems like a big promise to make to investors.

Attracting Investors

One reason is to attract certain kinds of investors. Some investors, especially big institutional investors like pension funds, really like the steady, reliable income that preferred stock provides. They’re willing to buy preferred stock even though it usually costs more than common stock.

Offering cumulative preferred stock can attract these investors even more, because it gives them extra protection. They know that even if the company has a bad year or two, they’ll still get their missed dividends eventually.

Raising Capital

Another reason a company might offer cumulative preferred stock is to raise money. When a company sells stock, they’re essentially selling tiny pieces of ownership in the company. The money they get from selling the stock can be used to grow the business, pay off debt, or for other purposes.

Cumulative preferred stock can be a good way to raise money because investors are often willing to pay more for it than they would for common stock, because of the extra protections and guaranteed dividends.

Balancing Risks and Rewards

Offering cumulative preferred stock is a balancing act for companies. On one hand, it can attract investors and raise money. On the other hand, it’s a big financial commitment. The company is promising to pay those dividends no matter what, even if they have to pay missed dividends from previous years before they can pay common stockholders.

This is why you often see cumulative preferred stock offered by larger, more stable companies. They’re more likely to have the consistent profits needed to keep up with the dividend payments.

Risks and Considerations for Investors

If you’re thinking about investing in cumulative preferred stock, there are a few things to keep in mind.

Lack of Voting Rights

Usually, preferred stockholders don’t get voting rights in the company. This means you don’t get a say in big decisions, like who is on the board of directors. Common stockholders usually do have voting rights.

Callable Stock

Some cumulative preferred stock is callable. This means the company has the right to buy the stock back from you at a certain price after a certain date. If interest rates go down, the company might call the stock so they can reissue it at a lower dividend rate. This is good for the company, but it means you lose your high-dividend investment.

Bankruptcy Risk

If a company goes bankrupt, preferred stockholders are paid before common stockholders, but after bondholders. There’s a risk you could lose your investment if the company’s financial troubles are severe enough.

Fixed Dividends

The dividends on cumulative preferred stock are fixed. This provides stable, predictable income. But it also means your dividends won’t grow if the company becomes more profitable over time, unlike dividends on common stock which can increase.