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Convertible preferred stock (known as preference shares in the United Kingdom) gives the holder the right to
exchange it at a fixed price for another security, usually common stock. The trick is knowing if, and when, to
exercise that right.
Getting Started
• Evaluating convertible preferred stock is principally an analysis of risk rather than of a company.
• Preferred stocks are listed as equity on a balance sheet, but they perform more like bonds than
common stock since most of these issues pay a fixed dividend set at the time of issue.
• While holders of preferred stock are entitled to a fixed dividend, they do not usually have voting rights.
• Preferred stocks are usually repayable at par value, and rank above the claims of ordinary
stockholders but behind bank and trade creditors.
• An expensive form of capitalization, preferred stock is typically used to finance growth opportunities
and capital expenditures, and to repay bank debt and nonbank short-term debt.
• Preferred stocks are often preferred by venture capitalists because they protect their investments
better, and offer them greater leverage and growth opportunities.
• US income tax considerations severely limit the appeal of preferred stock among individual investors,
but enhance it among corporations.
FAQs
How are repeated conversions of preferred stock prevented from diluting the value of
common stock?
The formula used to convert the convertible preferred stock into shares of common stock typically includes
an adjustment mechanism—an “anti-dilution provision”—that protects the investor against any dilution in
his percentage ownership caused by sale of cheaper stock to later investors. The nature and extent of the
protection afforded can be very important also to the holders of the company’s common stock: the greater
the protection against dilution given to the holder of convertible preferred stock, the more dilution common
stockholders are likely to suffer
Making It Happen
Like almost any stock consideration, evaluating convertible preferred stock opportunities and transactions is
based on research, market knowledge, and past experience.
It is essential first to understand what a company does and how it generates cash. The next question is
determining the likelihood of the company being able to pay its preferred dividends. The tools of choice are,
first, a common “coverage ratio” like EBIT or EBITDA, and, second, preferred stock ratings.
EBITDA is the acronym for “earnings before interest, taxes, depreciation, and amortization.” It usually
measures a company’s ability to handle debt service (interest payments), but can easily be adapted to
include preferred stock dividends. The ratio is:
EBITDA ÷ (Interest expense + Preferred dividends)
The higher the coverage ratio, the better.
Like corporate bonds, most preferred stocks are rated by such services as Standard & Poor’s and Moody’s.
Each rating service uses a slightly different rating system, but they have a similar basis: “A” is good, “AAA”
is better, and so on. A “B” or above is considered investment grade, but anything below that is regarded as
very high risk.
Another warning point is that, if a preferred stock is rated only by one of the second-tier rating agencies, the
likelihood is that the company’s management was unable to get a favorable rating from Standard & Poor’s or
Moody’s. The investor relations offices and websites of most corporations will provide the ratings. If they do
not, beware—although the websites of the rating services themselves will probably list them.
There are also some guidelines to follow. For instance, preferred stocks should have a higher yield than the
issuing company’s comparable debt (yield is the annual dividend divided by the price). This must be gauged
on a case-by-case basis.
There is another long-held contention that higher-quality companies issue standard convertible preferred
stock, while lower-quality companies issue convertible exchangeable preferred stock. Similarly, it is
maintained that only the “best” companies are consistently able to issue straight debt cost-effectively, while
medium-quality companies issue convertible securities, and lower-quality companies or high-risk companies
tend to issue additional common stock.
Conversion ratios and prices are other key facts to know about preferred stock. This information is found on
the indenture statement that accompanies all issues. Occasionally the indenture will state that the conversion
ratio will change over time. For example, the conversion price might be $50 for the first five years, $55 for the
next five years, and so forth. Stock splits can affect conversion considerations.
More Info
Book:
• Jenks, Philip, and Stephen Eckett. The Global Investor Book of Investing Rules. London: Harriman
House, 2001.