Cumulative vs. straight

The Board of Directors (BOD) must approve any dividend payments made to preferred stockholders. Most of the time, dividends are paid as expected. However, if a company runs into financial trouble, the BOD can vote to skip or suspend dividend payments.

Dividends are not a legal obligation. A company isn’t required to pay them, even though skipping dividends can hurt its reputation and make it harder to raise money in the future. Put simply: a company can’t distribute profits it doesn’t have.

Whether preferred stock is cumulative or straight (non-cumulative) determines what happens if dividends are skipped.

• If it’s cumulative, the issuer must pay any skipped dividends to preferred stockholders at some point in the future.
• If it’s straight (non-cumulative), the issuer never makes up skipped dividends.

Preferred stock is “preferred” because it has priority over common stock for dividends. Before an issuer can pay any dividend to common stockholders, it must first pay all required dividends to preferred stockholders.

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 preferred stock:

Cumulative

The company must make up past skipped dividends, plus pay 2022’s dividend to preferred stockholders before paying any dividend 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

Straight (non-cumulative)

The company is not required to make up past skipped dividends. Only 2022’s dividend to preferred stockholders must be paid before any dividend can be paid 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 this example, the difference is a $17 per share payout versus a $5 per share payout.

This is only for one share. With 100 shares, the difference would be $1,200 between the two types ($1,700 vs. $500).

Because cumulative preferred stock is more desirable to investors, it can typically be sold with lower dividend rates than straight preferred stock. This reflects a broader finance principle:

• When a security includes an added benefit for the investor, you can generally expect a lower rate of return (compared with a similar security without that benefit).
• When a security includes an added risk for the investor, you can generally expect a higher rate of return (compared with a similar security without that risk).