Large corporations tend to issue a few types of publicly-traded shares. In addition to common stock, which all public corporations have, some also issue a class of share broadly known as preferred stock. Preferred stock confers very different rights on the shareholder than common stock and comes in various flavors, including convertible and non-convertible varieties.
Preferred Stock Basics
Preferred shares are a hybrid between debt and equity, which means they resemble both stocks and bonds. Unlike common stock, a preferred share does not make the stockholder a partial owner of the corporation. Preferred shareholders cannot vote at the annual shareholder meeting and, therefore, do not influence the company's strategic decisions.
Preferred shareholders are entitled to receive a fixed annual dividend. These preferred dividend payments have legal priority over dividends payable to common shares. Until the company has honored all preferred payments, it cannot legally pay any money to common shareholders; hence the name "preferred stock."
Convertible Preferred Stock
A convertible preferred stock works exactly like a regular preferred stock but has an additional conversion clause. The shareholder can, if he so desires, submit the preferred stock to the issuing company and receive a predetermined number of common shares instead. The conversion ratio is always adjusted so that this conversion is not profitable at first.
Assume the preferred stock has a market value of $100 and the common stock is trading at $20. If the conversion ratio is four, the preferred stockholder can give up one of his preferred shares, worth $100, and receive four common shares, worth a total of $80. At these prices, the preferred stockholder is better off not converting his shares. However, if the price of common stock advances beyond $25 a share, the conversion becomes financially viable.
Limited vs. Unlimited Upside
A regular preferred stock has limited upside potential. Since the dividends payable to preferred shareholders are fixed, the value of preferred stock will not rise indefinitely as the company's profits grow. If the issuing corporation is already making far in excess of what it needs to honor preferred dividend payments, further increases in profitability are meaningless for the preferred stockholder.
If, however, the preferred stock is convertible, it has practically unlimited upside. The more the company earns, the more it can pay to common stockholders in the form of dividends, and the more the common stock can appreciate. Since a convertible preferred stock can be turned into common stock, it too can be potentially worth an unlimited sum.
Different Dividend Rates
Obviously, convertible preferred shares are superior to their non-convertible counterparts. After all, the conversion is at the discretion of the stockholder, who can simply continue to receive annual preferred dividends if he so desires.
The question then becomes, as an investor, why bother with non-convertible preferred shares at all? The answer is because a non-convertible preferred stock pays a higher fixed annual dividend than a similar stock with a conversion clause. Issuers are aware that the conversion clause is valuable privilege, and that they can get away with offering a lower dividend payment by making their preferred shares convertible.
The investor must therefore weigh whether he would rather get the unlimited but uncertain upside of a convertible preferred stock, or the higher guaranteed annual income from the non-convertible preferred stock.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.