Thursday, October 16, 2008

Is preferred stock equity?

In the last few days, we have seen announcement by both the UK and US governments of their intent to invest hundreds of billions into their biggest banks. In both plans, the investment will be in preferred stock in the banks, and the announcements have described them as investments in equity. But is preferred stock equity? That is a question that is not new but acquires fresh urgency, with these infusions.
Preferred stock is a hybrid security, sharing some characteristics with equity and some with debt. Like equity, it has a perpetual life and the dividends can be skipped, if a firm is in financial trouble, without the risk of default. Unlike equity, the preferred dividend is usually fixed at the time o the issue (as a percent of the face value of the preferred stock) and is often cumulative; failure to pay dividends one year is compensated for by paying the dividends in the next year. In fact, investing in preferred stock is more akin to investing in a bond than stock, with almost all of the returns coming from the dividends. There is one final confounding factor. While interest payment on debt are tax deductible, preferred dividends are not. In my discounted cash flow valuations, I have always considered preferred stock to be more debt than equity, and very expensive debt at that, since it does not provide a tax deduction.
Among US companies, the biggest issuers of preferred stock are the financial service companies (banks, insurance companies) and there is a simple reason for it. While it may be more expensive than conventional debt, it is counted as equity by the regulatory authorities while computing capital ratios for banks. 
So what is the bottom line of these capital infusions by the governments for existing equity investors in the banks receiving the infusions? If I were an investor in a US bank receiving the infusion, I am concerned about the effect of the preferred dividends that the banks have to pay for the foreseeable future out of after-tax earnings, which will lower my earnings and returns on equity going forward on common stock. However, given that the bank will have to raise capital to cover it's mistakes from the last few years, and that the capital will not come easily in this market (Think of the problems Bank of America had last week when it tried to raise $ 10 billion), I will accept this bargain. If I were an investor in a UK bank receiving capital from the British government, I am not so sure that this works in my favor. The British government plan is much more punitive to common stockholders; the dividend rate is set much higher, the banks will not be allowed to pay common dividends until they pay off the preferred stock and the government looks like it will take a much more active role in the way the banks are run. In other words, the British preferred stock infusion seems to encroach more on common equity than the US preferred stock infusion. Not surprisingly, the British banks that are prime targets for the infusion (Lloyds, HBOS and Royal Bank of Scotland) have seen their stock prices drop since the plan was announced, whereas the US banks have seen marginal improvements in the stock price.

11 comments:

Dennis Chiuten said...

I've been a little confused about how Mitsubishi UFJ's purchase of preferred shares in Morgan Stanley has been described as a 21% stake. To arrive at this figure, are they just dividing the value of the preferred shares by the total market of common and preferred stock? And would you characterize their purchase as a true "stake," given that it does not confer voting rights?

evileconboy said...

Well preferred and common stock both come after debt in bankruptcy proceedings, so why wouldn't it be equity? It's really no different than different classes of common shares with different rights.

Rajiv said...

I know it is not a right forum to ask this question, but I did not know any other way of contacting you directly.

Hope that you read this and respond

regards

rajiv bishnoi
***
A company - currently trading at $100/share (with a par value of $10 ) - last year paid $ 5 as dividend. Constant payment ( i.e. coming year also payment $5). Every year, company is also giving stock dividend of 10% i.e. 1 bonus share for every 10 shares held. ( Wishful thinking in these times, huh )

You are in middle of year .... just tabulating several stocks on their dividend yield ranking..... what % dividend yield you would give to this company??


a) 5% ( 5/100)

b) 13.63% ( ( 5+ 8.63 = 13.63 assuming the stock would fall after next dividend to 86.3 ( i.e. [(100- 5)/1.10]))

c) 6% ( 5+ 1 (10% of par value))

d) 15 % ( 5+ 10%)

e) any other answer

Aswath Damodaran said...

Reference the comment about the priority of claims in bankruptcy, not all debt gets the same claim. Senior debt gets paid first, then subordinated debt, then unsecured debt, preferred stock and then equity. Where do you draw the line?
Ultimately, you have to make a judgment based on much of a commitment you make on dividends and what role you take in the running of the company. That is why I would classify the British investment as more common stock than preferred and the US investment as a more conventional preferred stock investment.

Greg Donaldson said...

Aswath,

Is it your understanding that the British banks will continue to pay their preferred dividends? I have seen numerous statements about common or ordinary dividends, but nothing on the preferreds. There was a tremendous amount of European pfds sold in the US in the last 12 months, so the stakes are high, especially, as you say, since the governments there appear to be taking a bigger hand in decision making.

Boffo said...

Re Aswath Damodaran comments: "The British government plan is much more punitive to common stockholders."

This is not wholly correct:

(a)Unlike the US, the British Shareholder has been offered the right to invest on substantially similar terms - see for instance the RBS Rights Issue.

Additionally:

(b) Unlike the US in, for instance, the RBS case, the Government purchase of common stock ultimately was at a price of 2.5 billion pounds OVER the market.

Aswath Damodaran also wrote that:

"the dividend rate is set much higher"

This too seems incorrect - at least if measured on a spread to say 15 year swap rates or using an FX swap to compare like to like - which is clearly the appropriate measure that should be use to compare the relative interest rate costs given the different currencies.

Aswath Damodaran wrote

"the banks will not be allowed to pay common dividends until they pay off the preferred stock"

However this too is incorrect - similar measures are at work in Tarp

Aswath Damodaran wrote:

"the government looks like it will take a much more active role in the way the banks are run."

This too is incorrect - there is even an intermediary investment vehicle being used by the UK to ensure a 'hands off' approach.

The question asked by Aswath Damodaran about preferred however brings up a very important issue - the elephant in the room as itwere. Preferred's may be treated as Tier 2 capital precisely because their dividend rate may be cut without liability at times of loss. Indeed most bank preferred allow for dividend to be cut entirely at discretion of their board of director's.

There is therefore a direct conflict between the interests of the government as 'investor' of last resort and the concurrent existence of bank holding company pref shares still paying dividends. Part of the problem seems to be that to stop paying dividends and destroy any remaining pref share equity value (as with FNMA and FHLMC prefs) could be the final nail in the coffin that is the financial services industry stock market.

Ernest said...

I was wondering if a preferred stock dividend payment can be in the form of stock, like many US REITs are doing now with their common stock?

Also, can a company purchase its own preferred shares on the open market (at the current market price) or must they call the preferred shares at their initial offering price?

Thanks.

bhavik said...

Aswath,

FAS150 (GAAP) has been amended to treat preferred stock as debt in its balance sheet. If the regulatory authorities treat preferred as debt then the advantage of having debt equity ratios no longer holds. In view of that would you still consider preferred to be equity or debt
Please let me have your views
Bhavik

astrolog said...

See FAS150 - whether pref stock is treated as debt or equity depends on its terms. In the case of US banks for Pref shares to count to Tier2 capital- which most do - (and I simplify here) they must not have mandatory redemption (ie if redemption is contingent then it can count as Tier2.) In most cases also bank pref share dividend is entirely at the discretion of the board and usually depend on profitability. This is also true of many corporate prefs - eg look at NYSE listed f-s for Ford which has recently cancelled its dividends.
I suggest you look at the prospectuses - see quantumonline.com which has links to these....

Parag said...

Banks, insurers and real estate investment trusts are the most common issuers of Preferred stocks. With a preferred-stock ETF, you can diversify into utilities and industrials.

Unknown said...

Would you consider preferred stock as debts or equity? Discuss analytically