Current Dividend Preference and Example

What is Current Dividend Preference?

Current dividend preference is a safety feature of preferred shares, whereby holders of such shares are entitled to receive dividends before common shareholders. Current dividend preference means that preferred shareholders have priority or preference over common shareholders when it comes to dividend distributions. This feature implies that under no circumstances can dividends be paid to common shareholders before preferred shareholders.

Understanding Current Dividend Preference

Dividend distributions depend on a number of factors such as the company's operating performance, level of retained earnings, and payout ratio. While dividend payments on common shares are largely at the company's discretion, preferred dividends generally have a greater degree of stability.

Common shareholders have voting rights and get to participate in the growth of the company through common share price changes. Preferred shareholders usually don't have voting rights and are paid a fixed or floating dividend rate. The rate affects the price at which the preferred shares trade, making them a fusion of both a stock and a bond.

Dividend Rate and Preferred Stock

The dividend rate for a preferred stock is a fixed or floating amount based a predetermined metric. This makes them unlike common share dividends, which might fluctuate depending on a company's profits and are determined by the company's board of directors.

Generally speaking, preferred share dividends are viewed as more stable than common stock dividends, and have a higher probability of being paid, given that preferred stockholders are paid their full set dividend rate each period as long as the company is in operation.

One feature that often accompanies the current dividend preference is a cumulative preferred shares function, where all missed (cumulative) dividends on preferred shares must be paid before any dividends can be issued to common stock shareholders.

Another perk enjoyed by preferred shareholders arises if the company becomes insolvent and subsequently files for bankruptcy. In this case, preferred stock shareholders stand ahead of common stock shareholders should a bankruptcy court divide up a company's assets. However, preferred shareholders rank behind bond holders, so bond holders get paid before preferred shareholders.

Example of Current Dividend Preference

Consider a company called The World's Best Widget Co., which has four million preferred shares with a face value of $25 outstanding. These shares have a stipulated dividend of 5%.

The World's Best Widget Co. also has 100 million common shares outstanding, on which it has been paying dividends of $0.20.

This means that the company pays out $5 million in preferred dividends (0.05 x $25 x 4 million preferred shares) and $20 million in common share dividends (0.2 x 100 million common shares).

If the company has a healthy financial position and is consistently profitable, paying these dividends should not cause it any problems. However, if it has a couple of unprofitable or marginally profitable years, then it may consider trimming dividends on its common stock, or even suspending them altogether. But even in this scenario, it must pay out preferred share dividends, either during this period or at a later date.

If the company enters bankruptcy proceedings, preferred shareholders will be paid out any capital left over ahead of common shareholders. Bond holders are paid first, then preferred shareholders, then common shareholders.