The preferred dividend coverage ratio is one of the major ratios ideal for those investing in preferred stocks. 60% of investors prefer dividend coverage ratios when selecting stocks, showing its growing relevance in the stock market. As an investor, this ratio provides insight into a company’s ability to cover its preferred stock dividends from its earnings.
What is the Preferred Dividend Coverage Ratio?
The Preferred Dividend Coverage Ratio (PDCR) is an indicator that reflects the company’s dividend-payment ability on preferred stock. Since preferred stockholders get fixed dividends, payment can be made to common stockholders only after the company has settled all preferred dividend obligations. The PDCR is important for investors interested in dividend stability in preferred stocks.
The high ratio indicates that the company has made sufficient profits to pay preferred dividends comfortably. In contrast, a low ratio could mean liquidity issues or an inability to pay preferred dividends.
The Formula For the Preferred Dividend Coverage Ratio
Below is the formula for calculating the Preferred Dividend Coverage Ratio, which is quite straightforward:
Preferred Dividend Coverage Ratio = Net Income/Preferred Stock Dividends
Where:
- Net Income is the company’s earnings after deducting all expenses, taxes, and costs.
- Preferred Stock Dividends are the fixed dividends paid to preferred shareholders.
The company possesses sufficient earnings to fulfill its dividend obligations in times when it has a ratio above 1. In contrast, when the ratio is below 1, the company will probably experience an insufficient earnings figure for covering its preferred dividends.
Importance of the Preferred Dividend Coverage Ratio
One of the key indicators of a company’s financial health is the preferred dividend coverage ratio PDCR. This is important, especially if the company has preferred shares in its portfolio. Generally, preferred stockholders do not exercise voting rights but enjoy priority dividends over common stockholders, requiring a consistent ability of the company to cover such dividends.
- Security for Preferred Shareholders: A company’s ability to meet its dividend obligations is always key to preferred stockholders as they seek regular income, which means the PDCR is higher.
- Investment Decisions: This ratio is mostly used by investors to evaluate a company’s reliability based on the dividend payments, which can influence investment decisions.
- Risk Assessment: If the company has a very low PDCR, the investor who invests in its stock will consider it risky because it will not be able to pay out dividends if there is a variance in earnings.
How to Interpret the Preferred Dividend Coverage Ratio?
The preferred dividend coverage ratio varies according to the industry; above 2 is generally considered healthy. This means the company earns twice as much as it needs to pay out preferred dividends. Below 1 means the company is not earning enough to pay dividends on preferred stock, which would most likely lead to suspension or a cut in the dividend payout.
Example:
- Net Income: ₹10,000,000
- Preferred Stock Dividends: ₹4,000,000
Preferred Dividend Coverage Ratio = 10,000,000/4,000,000 = 2.5
In this example, the company has a PDCR of 2.5, which indicates it is in a comfortable position to meet its preferred stock dividend obligations.
Preferred Stock Dividends vs Common Stock Dividends
While both preferred and common stock dividends are payouts made to shareholders, they have the following differences:
| Feature | Preferred Stock Dividends | Common Stock Dividends |
| Priority | Its payment is done before common stock dividends | The payment is made after preferred stock dividends |
| Dividend Rate | The rate is always fixed, predetermined | The rate varies based on the company’s profits |
| Voting Rights | There are no voting rights | Voting can be done in shareholder meetings |
| Risk Level | The risk level is lower for income-seeking investors | The risk level is higher and depends on the company’s performance |
| Impact of Company Earnings | Less sensitive to earnings fluctuations | More sensitive to earnings changes |
Factors Affecting the Preferred Dividend Coverage Ratio
The following are some of the factors that can influence the PDCR, and understanding them is essential for making informed investment decisions:
- Company Profitability: A company’s ability to earn profits consistently impacts the company’s PDCR. If the earnings of a company experience a high level of fluctuation, the company may find it hard to stabilise the ratio.
- Debt Levels: High debt levels can affect a company’s net income and, consequently, its PDCR. Companies with significant debt may have higher interest expenses, which could reduce the funds available for dividend payments.
- Market Conditions: Market downturns or industry-specific constraints can lower the net income, thus reducing PDCR.
- Dividend Policy: Companies with aggressive dividend policies, especially privileging common stock dividends over preferred dividends, might have low PDCR.
Review Preferred Dividend Coverage Before Investing in Preferred Stocks
The Preferred Dividend Coverage Ratio is a crucial measure for estimating the capability of the enterprise to pay dividends on preferred stock. A higher ratio will assure investors of stable returns, while a lower ratio may signal impending financial trouble.
This ratio, coupled with other financial ratios, allows an investor to make sound investment decisions, especially in terms of comparing preferred vs common dividends.
Always consider the company’s financial health to ensure your investment aligns with your risk tolerance and income expectations. With the Dhan MadeForTrade community, investors can easily track and analyse stock performance, whether it includes preferred stock dividends.
