Preferred stock is so called because its holders have some priority over owners of common stock regarding dividends (and also in the distribution of assets if the company is liquidated or reorganized in bankruptcy). Preferred stock, which not all companies have, generally entitles the share owner to receive a fixed dividend before any payment can be made to the holders of common stock. Owners of preferred stock also carry a superior claim against assets if the corporation is liquidated. Some preferred issues are convertible into common stock at fixed exchange rates.
Two factors largely determine the value of a preferred stock: the price at which it is convertible into common stock and the level of its fixed dividend. Because the amount of a preferred stock's dividend typically does not change, these shares generally have many of the characteristics of fixed-income securities. Typically, there are smaller price swings with preferred stock than with common stock, so there is less risk. Common stock, however, provides a better way to maximize participation in the potential growth of a company. Preferred stocks do not accord voting rights that the common stockholders have, unless the company is financially unable to make its dividend payments.
Preferred stock is largely owned by institutions and corporations because provisions in the tax laws allow dividends that they receive from preferred stock to be largely tax-exempt. In contrast, dividends on preferred stock received by individual investors are fully taxable. Since most of the demand for preferred shares comes from tax advantaged buyers, who receive a higher after-tax yield, such stock is typically less attractive than other forms of investments for individuals.
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