The Board of Directors (BOD) must approve any dividend payments made to preferred stockholders. Normally, every dividend payment is made without question or issue. However, if a company is facing financial problems, the BOD could vote to skip or suspend dividend payments. Ultimately, dividends are not a legal obligation and are not required to be paid. Although it would look bad on the issuer and may have a long-term negative effect on their ability to sell other securities in the future, a company can’t share profits if they don’t have any.
Whether preferred stock is cumulative or straight (non-cumulative) will determine if the company must make up potentially skipped payments. If it’s cumulative, the issuer is required to pay any skipped dividends to preferred stockholders at some point in the future. If it’s straight, the issuer will not make up any skipped dividends, ever.
Preferred stock is “preferred,” meaning that it has preference over common stock when it comes to dividends. In order for an issuer to make a dividend payment to common stockholders, it must make all required payments to preferred stockholders first. Assume this example:
ABC Company $100 par, 5% preferred stock
- 2019 - ABC Co. skips their dividend completely
- 2020 - ABC Co. skips their dividend completely
- 2021 - ABC Co. pays 3% of their 5% dividend
If ABC Co. wanted to make a payment to common stockholders in 2022, here’s how it would look for both cumulative and straight:
The company must make up past skipped dividends, plus pay 2022’s dividend to preferred stockholders before dividend payments to common stockholders
Required dividend payments
2019: must make up the 5% missed
2020: must make up the 5% missed
2021: must make up the 2% missed
2022: must pay 5% before common stock dividend
The company must make a payout total of 17% ($17) to preferred stockholders
The company is not required to make up past skipped dividends; only 2022’s dividend to preferred stockholders must be made before dividend payments to common stockholders
Required dividend payments:
2019: will not make up the 5% missed
2020: will not make up the 5% missed
2021: will not make up the 2% missed
2022: must pay 5% before the common stock dividend
The company must make a payout total of 5% ($5) to preferred stockholders
As you can see, cumulative preferred stock is much more beneficial to investors if the issuer skips dividend payments. In our example, it’s the difference between a $17 per share payout and a $5 per share payout. This is only with one share; if you had 100 shares, it would be a difference of $1,200 between the two types ($1,700 vs. $500).
Cumulative preferred stock is more desirable to investors, therefore this type of preferred stock can be sold with lower dividend rates than straight preferred stock. The underlying concept is a generality throughout all of finance: when a security is issued with an added benefit to the investor, the investment can be expected to have a lower rate of return (vs. a similar security without the added benefit), and vice versa. When a security is issued with an added risk, the investment can be expected to have a higher rate of return (vs. a similar security without the added risk).
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