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16
Investing in
Preferred
Stocks
1
Preferred Stocks
and Convertible Securities
• Learning Goals
1. Describe the basic features of preferred stock,
including sources of value and exposure to risk.
2. Discuss the rights and claims of preferred
stockholders, and note some of the popular issue
characteristics often found with these securities.
3. Understand the various measures of investment
worth, and identify several investment strategies that
can be used with preferred stocks.
2
Characteristics of Preferred Stocks
• Hybrid security with characteristics of stocks
and bonds
• Preferred stockholders have a prior claim
(ahead of common) on the income and assets of
the issuing company
• Dividends are a fixed amount—a fixed dollar
amount or a percentage of the stock’s par value
• Investment quality is rated like bonds
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Advantages of Preferred Stock
• Dividend income is highly predictable
• Dividends yields are similar to yields on
high credit quality bonds
• Generally safe investments with good
track record of paying dividends
• Easy to purchase due to low unit cost
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Disadvantages of Preferred Stock
• Many preferred stock dividends do not qualify for
the new preferential tax rate of 15%
• If inflation and interest rates rise, the value of the
preferred stock drops
• If inflation and interest rates drop, the value rises
• Investors don’t participate in the capital gains
that common stockholders receive
• Preferred stock does not have the safety of a
bond, because dividends can be “passed”
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Valuing Preferred Stock
• Value is a function of the dividend yield provided.
• Value moves inversely to interest rates, similar to a
bond.
• The lower the investment quality, the higher the yield.
• Risk exposure of preferred stocks includes:
– Business risk
– Interest rate risk
Price of a preferred stock 
Annual dividend income
Prevailing market yield
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Issue Characteristics of Preferred
Stock
• Conversion feature: allows holder to convert to
a specified number of shares of a company’s
common stock
• Adjustable rate/floating rate: the dividend rate
changes with the market interest rate rather than
letting the value of the stock drop
• Preference (prior preferred): type of preferred
that has seniority over other preferred to receive
dividends and claims on assets
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Issue Characteristics
of Preferred Stock (cont’d)
• Cumulative provision: all past unpaid
dividends must be paid before common stock
dividends
are paid
• In arrears: past dividends that remain unpaid
and are an unfulfilled obligation of the company
• Noncumulative provision: company is excused
from paying all past unpaid dividends
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Key Measures of Preferred
Stock
• Dividend Yield
Dividend yield 
Annual dividend income
Current market price of the preferred stock
• Book Value
• Agency Ratings
• Fixed Charge Coverage
Fixed charge coverage 
Earnings before interest and taxes (EBIT)
Preferred dividends
Interest expense 
0.65
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Investment Strategies Using
Preferred Stock
• Two Major Strategies
– Going after higher levels of current income
– Seeking capital gains when market rates are falling
• Looking for High Yields
–
–
–
–
Used by long-term investors
High current income is primary objective
Certainty of income and safety are important
Yields typically lower than comparably rated bonds
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Investment Strategies Using
Preferred Stock (cont’d)
• Trading on Interest Rate Swings
– Investors buy on interest rate declines
– Short-term strategy
– Capital gains are the primary objective
• Speculating on Turnarounds
– Look for stocks with speculative ratings and
dividends in arrears that are about to undergo a
substantial turnaround
– Speculative and highly risky
– Returns “capped” at price of other investment-grade
preferred stocks
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Figure 16.1 Price Pattern
of Preferred Turnaround Candidate
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Chapter 16 Review
• Learning Goals
1. Describe the basic features of preferred stock,
including sources of value and exposure to risk.
2. Discuss the rights and claims of preferred
stockholders, and note some of the popular issue
characteristics often found with these securities.
3. Understand the various measures of investment
worth, and identify several investment strategies that
can be used with preferred stocks.
13
Table 16.1 A Sample of Some
High-Yielding Preferred Stock
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