Convertible Preferred Stock for Beginners

Preferred stock is a special type of stock that can be sold to investors as a step up from the company's common stock. Preferred stocks are named as such because they often feature higher dividends than common stocks, and they are first in line for payouts. There are limits to the total profit they can earn or the dividends they can collect. This puts them on a scale of payouts between common stocks and bonds.

Some companies have many "classes" of preferred stock. Each class has its own traits, voting rights, dividend rights, and other costs or perks. One of the most common classes of preferred stock is known as convertible preferred stock.

Here, you'll learn about some of the situations and scenarios you may run into if you decide to invest in these much less noticed, and discussed, securities, and how to make convertible preferred stock work in your favor.

Special Conversion Rights for Preferred Stock

If you are a new investor, it might seem odd that stock can change forms, but it is vital to know that some preferred stocks might have conversion rights. When this happens, people on Wall Street refer to these securities as convertible preferred stocks or convertible preferreds.

What Is the Process to Convert Stock?

The right to convert can be tricky. It may belong to the company, or to the shareholder, or it may be part of the trade itself. In simple terms, it means that the company might convert all of your preferred stock into shares of common stock at some future point. This can happen in a number of ways: either by your choice, through the actions of the board of directors, or at a predetermined date.

If you decide to purchase preferred convertible stocks, make sure you have a solid grasp of the terms and conditions of that conversion. It can mean the difference between major profits or massive losses.

Convertible Preferred Stock in Action

Suppose that after reading through the terms of the contract for a certain security, you decide to purchase 100 shares of convertible preferred stock in XYZ Bank. The preferred stock costs you $500 per share, so your total investment is $50,000. The class of preferred stock that you bought pays $25 per share each year in dividends, which works out to a 5% dividend yield. It also comes with a special conversion privilege, which states that you can convert each share of preferred stock into 50 shares of common stock.

The Nature of the Deal

Pause to think about that for a moment. Your preferred stock of $500 per share is paying you $25 per year in dividends, or a 5% yield. You also get a bonus feature that allows you to trade in your preferred stock and exchange it for 50 shares of common stock. That means your "cost" of converting to common is $10 per share ($500 preferred stock divided by 50 shares of common stock equals $10 cost per share in the event of conversion). This can be quite a handy tool if used well.

If the common stock is less than $10, your convertible preferred rights aren't worth much. If the common stock is $10 or more, your conversion rights can be a goldmine.

When to Keep Your Preferred Stock

If you wake up one morning and find that the common stock is $7, that would not be the time to use the conversion privilege. Recall, each share of preferred can be exchanged for 50 shares of common, or 100 preferred shares x 50 common shares = 5,000 common shares. If you decide to exchange your 100 shares of preferred stock, that would leave you with 5,000 shares of common stock at $7 per share, or $35,000. So when you compare it to the amount you first paid ($50,000), you're looking at a loss of $15,000. To make matters worse, you would no longer receive your preferred stock dividend.

When to Convert to Common Stock

Now, suppose that XYZ Bank made breaking news, and the common stock shot up to $30 per share. This would be the moment to take your 100 shares of preferred stock and convert them into 50 shares of common stock, each for a total of 5,000 shares of common stock. You could promptly sell your common stock for $150,000 ($30 per share x 5,000 shares = $150,000).

Your cost was only $50,000 when you first bought the stock, so you tripled your money. You also were able to collect dividends, right up until the time you used the conversion rights.

It's easy to see why learning the terms of your convertible preferred shares is so vital. You can also see why many people prefer this class of stock over common stock. It allows a level of control by the person who owns the shares (rather than falling at the full mercy of market forces) and can be used for great profit.