Investing in dividend stocks is something you might consider if you’re interested in creating passive income. There are different ways that dividends can be paid out, depending on which type of stock you own. Cumulative preferred stock distributes accumulated dividends on a preset schedule, before any dividend payouts to common stock shareholders. If you own cumulative preferred stock, it’s important to understand when you can expect to receive dividend payments.
Looking for professional help to reach your goals? Talking to a financial advisor can get you on the right track.
Understanding Cumulative Preferred Stock
Cumulative preferred stock is an equity investment that guarantees dividend payments to shareholders. Unpaid dividends–also referred to as dividends in arrears–accumulate and are then paid out at a future date. Those dividend payments are made before any dividends are paid out to common stock shareholders.
Shareholders collect a dividend payout at a fixed rate, which is set by the company. The dividend paid is typically calculated using the par value of the stock. Par value is simply the face value of a stock and usually doesn’t reflect its actual value in the market.
In a sense, cumulative preferred stock works similar to fixed-income securities such as bonds, in that payments are made to investors on a set schedule, at a set rate. Should the company liquidate for any reason, preferred stock shareholders would take precedence over common stockholders.
Non-cumulative preferred stock, on the other hand, allows the company to skip dividend payouts altogether, with no requirement to pay them at a future date. This type of preferred stock is less common and entails greater risk to investors since dividends are not guaranteed.
How to Calculate Dividends for Cumulative Preferred Stock
If you’d like to know how much you could expect to receive in dividends from cumulative preferred stock, there’s a fairly simple formula you can apply.
Dividend rate x Share par value = Cumulative dividend
In this formula, the dividend rate is the fixed rate the company uses to pay dividends. This rate is set when the shares are issued. As mentioned, the par value is just the face value. You’d then multiply the cumulative dividend by the number of years dividends have not been paid to find the total cumulative dividend payout.
Here’s another example. Say that a company set its preferred dividend rate at 7%. The par value of each share is $1,000. The company goes three years without paying any dividends. Here’s what the formula would look like 7% dividend rate x S1,000 par value = $70 cumulative dividend. If dividends are suspended for three years, then the total cumulative dividend for that time period would be $210 ($70 x 3).
What Is Cumulative Preferred Stock Used For?
In a nutshell, companies can use cumulative preferred stock shares to manage financial difficulties. Delaying dividend payments can allow an opportunity to regain equilibrium, without putting shareholders at risk of losing out on their investment.
Let’s say that a company experiences a steep decline in its stock value and as a result, opts to temporarily suspend dividend payments to reduce costs and improve cash flow. During that time, dividends continue to accumulate for cumulative preferred stock shares at a rate of 5%, based on a par value of $100 per share.
After two years, the company’s financial position has improved enough that it’s able to restart dividend payments. Assuming there are 10,000 shares outstanding, the company would owe $50,000 in dividends to its cumulative preferred stockholders.
(5% dividend rate x $100 par value) x 10,000 shares = $50,000
Those payments must be made before anything can be paid to common stockholders.
Benefits of Cumulative Preferred Stock
Issuing cumulative preferred stock shares can benefit companies if they need to temporarily halt dividend payouts for any reason. There are also some advantages for investors who hold these shares.
- Reduced risk: Cumulative preferred stocks can delay dividend payouts, but they don’t erase them. If you hold these types of shares, you’re guaranteed to receive your payment even if the company’s profits are uneven.
- Predictability: Calculating your dividend payout from cumulative preferred shares is relatively simple if you know the rate the company uses and the stock’s par value. Companies must also disclose unpaid dividends in financial statements so you can reasonably predict how much you should receive on the next payout date.
- Payout priority: Investors who hold shares of cumulative preferred stock take precedence over common stockholders when it’s time for dividends to be paid. They also get priority for payment should the company liquidate.
Drawbacks of Cumulative Preferred Stock
While the cumulative preferred stock has some advantages, there are a few things to keep in mind before you invest.
- No voting rights: Cumulative preferred stockholders do not have voting rights, meaning they don’t have a say in company decision-making. That could be a downside for investors who prefer a more active role.
- Lower dividends: Since dividends are fixed, you’ll have predictability with your investment in cumulative preferred stock. However, the dividend you receive may be less than what common stockholders collect if the company returns a higher-than-expected profit in any given year. Additionally, fixed dividends may not keep pace with rising inflation.
- Higher cost: Cumulative preferred stock can yield benefits that you wouldn’t get with common stock. However, you might pay more per share for cumulative preferred stock to enjoy those privileges.
Should You Invest in Cumulative Preferred Stock?
Cumulative preferred stock might be a good fit for investors who want a degree of certainty in their portfolio. Since dividend payouts are guaranteed, these stocks can lower your risk exposure. Even if the company were to liquidate entirely, cumulative preferred stockholders would still be able to walk away with something.
On the other hand, it’s important to remember that there’s always risk involved with any type of stock investment. The biggest with cumulative preferred stock is that the dividend you receive either doesn’t keep up with inflation or lags behind the payouts made to common stockholders.
Considering your portfolio as a whole as well as your risk tolerance and goals can help you to decide whether cumulative preferred stock may be a good fit in place of or alongside other types of dividend stock. You can also talk to a financial advisor about formulating a dividend investment strategy that’s tailored to your goals.
- Dividend stocks aren’t the only option you have for generating passive income. You might also consider investing in bonds, real estate, index funds or even annuities if you’re getting closer to retirement. If you’re not sure which investments might be right for you, a financial advisor can help you figure it out. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Dividend reinvestment plans (DRIPs) can make it easier to grow your portfolio without investing more money out of pocket. These plans allow you to reinvest your dividends into additional shares of the same stock.
Photo credit: ©iStock.com/shih-wei, ©iStock.com/whitebalance.oatt, ©iStock.com/ridvan_celik