Preferred Stock on the Income Statement
Many investors, both new and experienced, aren't likely able to explain what preferred stock is and how it factors into their valuation of a company's worth. With that said, let's discuss the role of preferred stock on the income statement; how it influences the reported profit and loss in companies with large preferred stock issues.
Although we touched on it in the last lesson when I introduced you to common stock, preferred stock, and convertible stock, the reason it's coming up now is because, if you've been following along with my past lessons by looking at a real income statement from an annual report or Form 10-K filing, you'll have encountered the net income figure.
Net income represents the total after-tax profit the business made for the period prior to deducting the required dividends that were paid on the company's outstanding preferred stock. Understanding the thinking behind deducting the preferred dividends matters if you want to be a good investor.
The reason we can't rely on reported net income as it appears at this point has to do with the nature of preferred stock and preferred stock dividends. Regular cash dividends paid on the ordinary common stock are not deducted from the income statement. In other words, if a company made $10 million in profit and paid $9 million in dividends, the income statement would show $10 million, the balance sheet $1 million, and the cash flow statement $9 million in dividends distributed.
Preferred stock dividends, on the other hand, more closely resembles interest paid on debt in terms of what they mean for the owner of the common equity; obligations that almost always have to be paid and can't be skipped without some unpleasant consequences in the marketplace, potential lawsuits, and major reputation damage that makes it more difficult to raise capital in the future.
That is the reason many companies include them on the income statement and then report another net income figure known as "net income applicable to common", which you'll learn about later in this article. If a company earned $10 million after taxes and paid $1 million in preferred stock dividends, the net income applicable to common would show only $9 million on the income statement.
Understanding the Nature of Preferred Stock
To be more specific and build upon what is touched on in The Many Flavors of Preferred Stock and How To Calculate the Intrinsic Value of Preferred Stock, plain-vanilla preferred stock without unique features such as the right to be converted into common stock (known appropriately enough as convertible preferred stock) is a type of perpetuity.
In essence, it acts like a mixture of a stock and a bond with each preferred share normally paid a guaranteed, relatively high dividend. In the event the company ever goes bankrupt or is liquidated, preferred stock is higher in the capital structure, behind the bondholders and certain other creditors, to receive any remaining distributions from the windup or reorganization.
In exchange for this higher income and relative safety, preferred stock is not entitled to share in the success of the business beyond the dividend unless it is a special type known as participating preferred stock. Even then, the participation won't be comparable to common stock and will include some sort of upside calculation that may enrich the dividend payment during boom periods. Rather, in an extraordinarily successful enterprise, as long as things go well, year after year, you collect your preferred dividends while the common stockholders get obscenely rich.
Preferred stock may or may not have voting rights.
Some companies have many different preferred stock issues all at once; adjustable rate preferred stock, convertible preferred stock, first preferred stock, participating preferred stock, participating convertible preferred stock, prior preferred stock, and second preferred stock; different dividend rates, perhaps different par values. The dividends from all of these need to be deducted from net income on the income statement before arriving at the net income applicable to common figure.
That is because, in nearly every instance, the corporation's by-laws forbid the payment of any dividend on the common stock unless the dividend on the preferred stock has been paid. That is, from the perspective of a common stock investor, the preferred stock dividends are required payments that must be made before it becomes possible to take some of the earnings out of the business and enjoy them, every bit as real as payroll or taxes.