Definition
Cumulative Preferred Stock is a type of preferred stock that comes with a provision stating that, if any dividends have been omitted or skipped, they must be paid out in the future before any dividends can be paid to common shareholders. Holders of these stocks are entitled to receive their accumulated dividends before any dividends are distributed to common stockholders. This makes them particularly attractive during situations where a company might struggle to maintain consistent dividend payments.
Key Takeaways
- Cumulative Preferred Stock is a type of preferred stock where any missed dividend payments are accrued and must be paid out before common dividends can be distributed.
- This stock option provides investors with a more stable dividend income, making it a less risky investment compared with common shares, as it guarantees the holder to receive dividends before the common shareholders do even if the dividends are skipped or inadequate at times.
- The cumulative in cumulative preferred stocks indicates the compounding ability of this stock type to roll over due dividend payments to the next dividend cycle if they aren’t paid out during the present cycle.
Importance
Cumulative Preferred Stock is a vital part of finance because it carries a provision that safeguards the interest of its holders.
This types of preferred stock guarantees that if any dividends are missed or not paid in full amount, they accumulate and must be paid out before dividends can be paid to common shareholders.
The accumulated unpaid dividends are usually dispensed when the company regains its financial stability or when liquidation happens.
This attribute makes it more appealing to investors as it introduces a safety net and reduces the level of risk associated with their investment, thereby attracting more funds for the company.
Hence, Cumulative preferred stock can be an essential financial tool for both investors and companies.
Explanation
The primary purpose of Cumulative Preferred Stock is to provide stockholders with a superior claim on the company’s earnings and assets. This type of stock generally comes with a fixed dividend that is to be paid out to its holders before any dividends can be paid to common stockholders.
This means that even in periods when a company may not generate sufficient profits, or when it incurs losses, cumulative preferred stockholders still retain their entitlement to receive dividends. Another key use of Cumulative Preferred Stock is related to its ‘cumulative’ feature.
In cases where a company may not be able to pay out dividends in a particular period, the owed dividend amount accumulates and needs to be paid out in full to these stockholders before any dividends can be paid to common stockholders in future periods. This accumulation feature therefore acts as a form of additional security for investors, making Cumulative Preferred Stock a more attractive and less risky investment option, especially in unstable and unpredictable economic environments.
It can be a powerful tool for companies to raise capital while providing strong return assurances to their investors.
Examples of Cumulative Preferred Stock
Ford Motor Company: In 2002, the Ford Motor Company issued cumulative preferred stock where dividends are accumulated for future payment in case of missed payments. This meant that if Ford was unable to pay dividends in a year, those dividends were not lost, but were instead accumulated and must be paid out to the preferred shareholders before common shareholders can receive their dividends.
Bank of America Corp.: During the 2008 financial crisis, many traditional banks like Bank of America issued cumulative preferred stocks. These instruments were used to raise capital while reassuring investors that they will get their dividends paid even if the company miss any payments.
Wells Fargo & Company: Similar to Bank of America, Wells Fargo also issued cumulative preferred stocks during the financial crisis. In Wells Fargo’s case, the cumulative preferred stock ensured investors that even if Wells Fargo was unable to pay out dividends due to economic conditions or any other reasons, the shareholders would receive all missed dividends once Wells Fargo were financially able to do so, before any dividends were distributed to common shareholders.
Frequently Asked Questions about Cumulative Preferred Stock
What is Cumulative Preferred Stock?
Cumulative preferred stock refers to shares that have a provision which states if any dividend payments have been missed in the past, they are to be paid out to cumulative preferred stockholders first. This type of stock is sought after for its cumulative dividend right.
What is the difference between Cumulative Preferred Stock and Non-cumulative Preferred Stock?
The main difference between cumulative and non-cumulative preferred stock lies in dividend payments. With cumulative shares, missed dividends payments accumulate and must be paid out before any dividends on common shares. Non-cumulative stocks do not have this provision and missed dividends do not accumulate.
What are the advantages of owning Cumulative Preferred Stock?
Ownership of cumulative preferred stock offers advantages such as dividend preference and possible collection of missed dividends. These stocks have a higher claim on dividends and assets than common stocks though they generally do not come with voting rights.
How is Cumulative Preferred Stock valued?
The value of cumulative preferred stock is calculated based on its dividend amount which is usually fixed, and the current market interest rate. If the interest rate rises, the value of cumulative preferred stocks will fall and vice-versa.
Related Entrepreneurship Terms
- Dividends: These are regular payments made by a corporation to its shareholders, often coming from a portion of its profits. Cumulative preferred stockholders have the right to accumulate dividends in case they are not paid.
- Par Value: In finance, this is the face or nominal value of a security, as determined by the issuing entity. For cumulative preferred stock, the par value is important as dividends are often paid as a percentage of this value.
- Liquidation: This refers to the process of closing down a business and distributing its assets to claimants. Cumulative preferred stockholders have a higher priority than common stockholders during liquidation.
- Preference Shares: These are shares that have certain privileges that common stock does not. Cumulative preferred stock belongs to this category because holders have the benefit of receiving accumulated unpaid dividends.
- Arrears: This refers to unpaid or overdue debts. In cumulative preferred stock, if the company skips a dividend, these missed payouts accumulate as arrears and are owed to the stockholder.
Sources for More Information
- Investopedia: This website is a leading source of financial content on the web, with extensive definitions and explanations of various financial terms and concepts.
- The Motley Fool: An investing advice website that offers a wide range of articles on stocks, investing, and finances, including topics like preferred shares.
- New York Stock Exchange (NYSE): As one of the world’s largest marketplaces for securities and other exchange-listed investments, the NYSE provides a wealth of information about different types of stock, including cumulative preferred stock.
- Nasdaq: This website provides timely, high-quality financial content, including an extensive financial glossary with a wide variety of terms related to the stock market and investing.
