Like many investors, you’ve sunk your money into a major company in the hopes of receiving dividends. But recent poor performance means that no dividend payments are distributed that year. Fortunately, you’ve invested in cumulative preferred stock, so you’re not worried.
Cumulative preference shares give you greater security in your investments and ensure that you receive the dividend payments you’ve been promised. Here’s how.
What Is Cumulative Preferred Stock?
How do you define cumulative preferred stock? Cumulative preferred stock (sometimes called “cumulative dividend preferred shares”) is a type of preferred stock that provides assurance for dividend payments.
If any dividend payments have been missed in the past, the dividends must be paid to cumulative preferred shareholders prior to any other shareholder. This means that cumulative preferred shareholders take greater priority over even preferred shareholders.
Like other types of preferred stock, the shares typically have a fixed dividend yield based on the stock’s “par value.” The par value refers to the value of the stock as declared on the company’s corporate charter. It is sometimes referred to as the “face value” of the stock.
When Do Shareholders Receive Their Cumulative Dividends?
You may recall that dividend payments usually come from the company’s profits. But during a lean period, the company might not have profits to spread around, or they may need to use that working capital to focus on essential areas of their business.
When this happens, dividends may be suspended. This means that no shareholder will receive dividends for as long as the company deems fit. Fortunately, suspending dividend payments can be bad for the company’s public reputation, so this isn’t typically a long period.
However, once dividend payments resume, shareholders are not ordinarily eligible to receive their back payments. The exception, as you may have guessed, is those who hold cumulative preference shares. These shareholders will receive their back payments in full.
In fact, cumulative preferred shareholders will receive their dividend payments before any other shareholder begins receiving dividend payments.
Example of a Cumulative Preferred Stock Dividend
Imagine that you own cumulative preferred stock in Company X. This company has a par value of $5,000 and an annual dividend payment rate of 6%. This means that every year, shareholders can expect to receive $150 per share ($5,000 x 6%).
One year, business slows, and Company X chooses to suspend dividend payments in order to invest in a new marketing campaign and a new software platform. No shareholder will receive their dividend payments that year.
Now, imagine that this trend continues for another year. This means that two years have now passed, and shareholders have missed out on $300 worth of dividend payments ($150 x 2).
Fortunately for Company X, their investments paid off. By year three, Company X is back and more profitable than ever, now able to offer dividend payments of $200 per share. This means that cumulative preferred shareholders will receive a total of $500 that year ($200 in this year’s dividend plus $300 in back dividends).
Once the premium preferred shareholders receive their full payment, the rest of the shareholders will receive their $200 for that year. Again, notice that only cumulative preferred shareholders will receive all dividend payments. And only when they receive their full cumulative preferred stock dividend will other shareholders receive their stock dividends.
Advantages of Cumulative Dividend Preferred Stock
Cumulative dividends offer a number of core benefits. These advantages include:
Less Risk Compared to Preferred Stock
Naturally, cumulative redeemable preferred stock provides greater security than other forms of dividend stocks. Cumulative preferred shares ensure that you’ll receive dividend payments regardless of how the company performs.
Even if the company is unable to provide you with dividend payments for a year or more, investors can still be confident that they will receive back payments once the dividends resume.
Preference over Preferred Shareholders If Company Liquidates
Cumulative preference shares sound great as long as the company eventually rebounds. But what happens if the company goes under entirely?
If that happens, cumulative preferred shareholders still have the advantage. In the event of a liquidation, cumulative preferred shareholders will receive payments before all other shareholders, including preferred shareholders.
Higher Rate of Return During Profitable Years
While this is not always the case, some companies offer cumulative preferred shareholders a higher rate of return during profitable years. Again, this is not a guarantee, but it still means that cumulative preferred shareholders have a financial advantage over other preferred shareholders.
Incentive for Non-Voting Members
As with any form of preferred stock, cumulative preferred shareholders are not eligible to vote in company decisions. For stockholders, this means less control over corporate policy.
But companies themselves may prefer this arrangement, as it offers more control over the direction of the company. Cumulative preferred stocks encourage shareholders to invest without losing control over the company’s financial decisions or strategic policies.
Disadvantages of Cumulative Dividend Preferred Stock
Despite these advantages, there are still some risks associated with cumulative preferred shares. These risks include:
Higher Cost
In most cases, cumulative preferred shares will be more costly per share as compared to other types of stock shares. This means that investors will have to decide whether the guaranteed dividend payments are worth this additional cost.
Possibility of Inconsistent Payments
Dividend payments are a great way to earn some passive income from your stock portfolio. But cumulative dividends mean that you won’t necessarily get the same dividend payments each year.
True, you’ll receive this money eventually, and late is always better than never. But that still means you can’t count on these investments to bring a steady stream of annual income.
No Voting Rights
As noted above, cumulative preferred investors will have no voting rights. If you were hoping to exert some influence over the direction of the company, you cannot do so with cumulative preference shares alone.
Less Working Capital
For the company itself, cumulative preferred dividends can take a significant bite out of the cash flow. In other words, making good on past dividend payments might mean that they have less working capital during the year that dividend payments resume, especially if it’s been a few years since dividends have been faithfully paid.
Bottom Line: Are Cumulative Preferred Stocks Right for My Portfolio?
Dividend stocks are great for investors who want to accumulate money drip by drip. Dividend payments typically aren’t huge, at least compared to the value of the company itself. Still, they can provide you with some helpful passive income, and you can always use the dividend payments to invest back into the company and grow your investment.
Even financial experts agree that preferred stocks are more reliable than common stocks, and a cumulative preferred stock may be the most reliable yet. A cumulative redeemable preferred stock allows you to collect dividend payments with no risk of missing a year. This can make them a reliable investment vehicle for your portfolio, with less risk than other forms of dividend stocks.
With that being said, you’ll need to carefully research these stocks to determine whether the benefits justify the higher cost per share. In some cases, the guarantee of dividend payments won’t be worth the higher investment cost, and you’ll be led to look for alternatives.
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