The Preferred Treatment

When lending standards toughen, companies work to improve their liquidity positions. One of the easiest ways to improve liquidity is by cutting dividend payments: unlike cutting marketing or research expenses, a company doesn't hurt its operations by saving money by way of stopping its dividend.

However, preferred stock dividends are often cumulative, meaning if payments are put on hold, they must eventually be paid out before common stockholders receive a dime. As such, it is important for investors of common stock to take into consideration the value of cumulative dividends owed. These will not show up as liabilities on the balance sheet, but for common stockholders they most certainly are liabilities! Therefore, they must be manually subtracted from an investor's valuation of a company, along with the value of the preferred shares themselves.

On the flip side, this represents an opportunity for investors willing to foray into the preferred stock space. As discussed in this chapter of Security Analysis, some healthy companies act conservatively and do not pay out preferred dividends for years at a time. As such, they have cumulative dividends owing. When the company is ready to pay common stockholders, these cumulative dividends in arrears have to be paid out first, to the current holders of the preferred shares. Therefore, purchasing preferred shares where large cumulative dividends are owed can represent great upside if the company's financials are sound.

This article was written by Saj Karsan of Barel Karsan. If you enjoyed this article, please vote for it by clicking the Buzz Up! button below.