I recently wrote a post about the pros and cons of preferred equity, but did you know that there are actually is a type of preferred equity that the company can decide to pay you off for your shares? Let me tell you all about redeemable preferred stock!
First off, if you’re unfamiliar with preferred equity, I really encourage you to go read my post about it that not only will give you the 101 but also will leave you with some tangible takeaways that you can implement to invest in preferred stock. I think starting with that article will give you a great baseline to be able to comprehend this info, but that’s just my opinion!
The Basics of Redeemable Preferred Stock
Redeemable Preferred Stock is stock that give companies the option to “redeem” their stock and effectively retire those shares. Now, the price that the company has to pay is a price that is predetermined at the time of those redeemable preferred stocks being issued, so there isn’t an opportunity for some manipulation to occur.
Typically, the company has to buy these shares back on a certain date, with the first opportunity being around 5 years.
The benefits for a company are really pretty significant. By the company having the ability to buy back these shares at a pre-determined price, if they can buy back the shares at a price that is lower than the current share price then they’re instantly going to be better off.
For instance, maybe the company issues shares at $10/share and sets a redeemable price at $100/share. Well, if the share price is up to $150 by the time that the company is allowed to redeem them, they’re going to be able to pay $100 and redeem a share that would have cost them $150 than if they were simply doing a share repurchase.
In addition to that, the company will likely be paying a higher dividend than what the common shares are being paid, so the company will be able to immediately reduce their total dividend spend by redeeming these shares.
A higher dividend is one of the main benefits that an investor is going to have when investing in preferred equity, so it’s a pretty safe assumption that the company will be saving money when retiring these shares.
The Effect of Redeemable Preferred Stock to the Company
And finally, the last main benefit that the company is going to have, which also is a major benefit to the investor, is the fact that their total outstanding shares are going to decrease.
What that means to the company is that even if they have the exact same amount of earnings but their total outstanding shares decrease, then they’re going to be able to report more earnings per share, or EPS. Truthfully, it really acts the exact same as what a share repurchase program, or share buyback program, would be doing.
For instance, let’s pretend that a company has $50 million in annual earnings and has 20 million outstanding shares, meaning their EPS is $2.50, as you’re taking 50 million/20 million.
Now, let’s imagine that the company decides to buy back and retire their redeemable preferred stock from those shareholders, and let’s assume that accounts for 2 million shares. The earnings are not changing, but since the shares are being reduced, the EPS is growing:
This is a benefit to the company because many investors will use EPS as a major valuation ratio for the company, but this is exactly why I like to avoid EPS because companies can manipulate it. Regardless, it is undeniably a benefit for the company because it’s going to increase investor demand and interest.
If investors deem that this company is worth a 15x multiple on their earnings, aka a P/E of 15, then that means that their shares are now worth more!
When the earnings stay the same and the shares decrease, you can see the drastic impact that it has on the share price, below:
As an investor of common shares, your investment just increased in value by 11.11%! Not too bad for doing nothing.
And this really helps the company as well because investors love when you buyback shares because it shows you’re doing things to put money in their pocket.
More investor demand means more investors buying shares, and all of that means continually rising share prices!
Benefits to the Investor
So, what are some of the potential benefits that an investor might realize?
Well, in my opinion, there is really one major benefit. When you invest in redeemable preferred stock, your end goal really is to have your shares redeemed, right?
When you first got your shares, there also was a limit that was announced that the company could basically buy you out from your shares and then you could take the money and run. Sure, you were able to capture a pretty hefty dividend the entire way, but your main goal is obviously to maximize your return, and the way to do that is by getting your shares redeemed.
You did it! Your investment paid off. When you invested, you knew that was the best outcome that you were able to receive, so take it and run!
Sure, your investment might’ve returned less than what some of the stockholders of the common stock have, but this is a pro and con with being a preferred stock shareholder.
You are going to get the benefit of a much more protected (and higher) dividend, as well as having priority over common shareholders in a liquidation event, but you’re going to give up some of the upside.
I have heard of people refer to preferred stock as investing in bonds, and I really do think that this is a fairly decent comparison. You’re essentially limiting your downside but at the same time you’re capping your upside.
It really is no different than with a lot of investment options that we have. Typically, the greater the risk the greater the opportunity for return and the opposite is true as well.
Fortunately for us, there actually is a way to try to find some undervalued stocks that have a lot of upside with some back-testing data to make sure that they’re not value traps on their way to bankruptcy!
How do you get that data, you ask? Well, my friend, it’s with the Value Trap Indicator!