Sunday, March 22, 2009

Who uses preferred stock?

In my last post, I made the argument that preferred stock is very expensive debt. To give you a sense of the differences in costs between the different types of financing, consider a company like GE that has common stock, preferred stock and conventional debt outstanding. In March 2009, the cost of equity was close to 12%, the preferred dividend yield was about 9-10% and the pre-tax cost of debt was about 6-7%. On an after-tax basis, the pre-tax cost of debt was closer to 4%.

To understand why firms use preferred stock, given its high cost, we have to look at the two groups of firms that are its biggest users - financial service firms and young, growth companies.

1. With financial service firms, the allure comes from the way regulatory authorities define equity capital for capital ratios. They generally include preferred stock in equity. Thus, preferred stock may be considered expensive debt that gets treated as regulatory equity - a big bonus for firms that get judged based upon their capital ratios. (To add to the problem, ratings agencies also seem to treat preferred dividends as quasi-equity... giving higher ratings to these firms than they truly deserve, given their cash flow obligations).

2. With young, growth companies and some distressed companies, there is a different reason. Since these firms are often losing money, debt does not provide a tax advantage anyway. From, the firm's perspective the difference in costs between debt and preferred stock narrows, as a consequence. From the investors' perspective, the allure of preferred stock is that it is generally cumulative (dividends not paid have to be made up for in future years) and convertible to common stock. Thus, the investors, while running the risk of not receiving preferred dividends during the bad years, get priority in claims to cash flows (if the company starts making money) and can use the conversion option, if the firm's market value also climbs.

If nothing else, the existence of preferred stock is a testimonial to the effects that regulatory and tax laws have on financing choices. Bad laws (and regulatory definitions) will create bad financing choices. We may be seeing this play out in the current crisis. In my view, banks, insurance companies and investment banks that faced capital constraints would have been better off raising common equity early in this crisis rather than go for preferred stock from unconventional sources. Even those banks that thought they were getting a good deals on preferred stock (from the government) are discovering that there are implicit costs in these deals.

10 comments:

not-so-erudite said...

Professor--I think you are being a bit unduly harsh regarding preferred stock. Yes, in some respects it looks like very expenseive debt, particularly on an after-tax basis. But preferred stock has special attributes and needs to be viewed as sui generis. From an investor's perspective it has its own risk profile, ranking between debt and equity in bankruptcy. An unlike with debt investors are subject to dividends being passed without triggering default (though companies can't pay common dividends if they owe on preferred). From an issuer's point of view I suppose it is fair to say that there are reasons that regulators often treat preferred as a component of capital, though not as favorably as common. Generally, such regulatory preferred has to be perpetual or at the very least very, very long-term (with regulatory credit decreasing as maturity approaches) and as noted already the issuer has increased flexibility to pass dividends, though in the case of cumulative these will hve to be made up eventually if earnings are available. So I think that preferred stock can play a useful and appropriate role in corp finance and capital structure, though I agree with you that in the current crisis it probably wasn't the best choice for the banks.

Aswath Damodaran said...

Here is a compromise. Let us call preferred stock flexible debt - it does give you advantages when it comes to default risk. However, a tax paying company pays a huge cost for using preferred stock. i will wager that if you took away the two categories of firms that I listed in my post, that the bulk of preferred stock issues woulld cease.

not-so-erudite said...

Actually, I don't see much use for it outside of the regulatory capital sphere. Though I can tell you from personal experience that lots and lots of company CFOs have tried to use preferred stock as window dressing to meet target ratios and bank covenant limitations. NOT a good use!

UIUCFINANCE said...

One thing that leaves me a bit confused is why it is an "expensive" method of raising funds.

Shouldn't the market supply these funds until the costs reaches equilibrium, i.e. not "expensive".

It seems to me it is more expensive than typical debt in nominal terms, but if the market is efficient, the difference in nominal rates is deserved, again not "expensive".

Aswath Damodaran said...

The market will deliver an equilibrium return, given the risk in the investment. Thus, the preferred dividend yield will be higher than the pre-tax cost of debt but lower than the cost of equity. What makes it expensive is the tax laws that are titled towards debt. The market can and should do nothing about those tax savings.. That is why the after-tax cost of debt is so much lower than the preferred stock cost.

ZZ said...

Prof ... how do I add rss feed for your blog?!

ZZ said...

ignore the previous comment,, i got it!

Swati said...

Prof,

It would be nice if you could give your opinion about the latest move of FASB (the relaxation of the Mark to market accounting rules) and what sort of an impact it would have in the long term.

Uiucfinance said...

Paint over cracks!

astrolog said...

Read the fine print of the prospectus. Perpetual preferred stock has no obligation to pay either a dividend or to redeem. This means financial institutions were effectively raising capital at Zero interest and Zero redemption. HOWEVER like everything else confidence is everything and despite having gone through the financial superstorm all major banks (other than the insolvent) are STILL paying dividends on their prefs although there is no compulsion to do so. Why do you think the UK is now converting UK Treasury held pref shares to equity - I suspect in advance of the next wave when pref share dividends will be cut. Compare this to Ford's Pref Convertible on NYSE - F-S which has recently cancelled its dividend.