Preferred stock doesn't get as much attention as its common-stock counterpart, but income investors often choose preferred stock because of its typically higher dividend yields. Every preferred stock investor needs to understand that preferred stock comes in two types -- cumulative and noncumulative -- and which you own can have a huge difference in how much you eventually receive in dividends over the long run.

The basics of preferred stock
The concept of preferred stock is pretty simple. Investors who own preferred stock have two advantages over common shareholders: they enjoy a liquidation preference ahead of holders of common stock if the company liquidates, and they have a right to receive preferred-stock dividends before common shareholders are entitled to any dividend payments.

Traditional preferred shares tend to behave more like bonds than stocks, with share prices hovering near their redemption value and with yields that reflect their position in the capital structure as subordinate to every bondholder the issuing company has. Unlike bonds, though, preferred shareholders don't have any intrinsic right to the dividends the company pays. If the company chooses not to pay dividends on preferred stock, the only limitation that creates is that the company can't pay any dividends to its common-stock holders, either.

Cumulative vs. noncumulative
The question that comes up when a company chooses not to pay a preferred stock dividend is what happens in the future. That's where the difference between cumulative and noncumulative preferred stock comes in.

With cumulative preferred stock, the company must keep track of the dividends it chooses not to pay to its preferred shareholders. If it later decides to start paying dividends again, cumulative preferred shareholders are entitled to receive all of their previous missed dividend payments before the company can pay common shareholders anything. To calculate the accumulated dividends, you look back to the last paid dividend and then count how many dividend payments the company skipped. Then multiply by the dividend rate for the preferred stock, and that will give you the amount of the dividend the company must pay before restoring a dividend to common shareholders.

By contrast, if a company issues noncumulative preferred stock, its preferred shareholders have no future right to receive dividends that the company chooses not to pay. If the issuer starts making its regularly scheduled preferred dividend payments again, it only has to become current and can then start paying common-stock dividends as well if it wishes. No calculation is therefore necessary.

You can see how the difference between cumulative and noncumulative preferred stock can have a big impact on value. The more troubled a company is financially, the greater value a cumulative preferred has over noncumulative preferred.

Preferred shares aren't as popular as common stock investments, but they can be a good income investment. Be sure when you buy preferred stock that you know whether it's cumulative or noncumulative so that you don't get any surprises if the issuer stops paying dividends in the future.

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