How Do I Evaluate Preferred Stocks?

NEW YORK ( TheStreet) -- How do I evaluate preferred stocks? For instance, Goldman Sachs has four different preferred issues; how do I find out how they're different? -- B.A.

Simon Constable: Before we get to specifics about Goldman Sachs ( GS) and its four preferred classes, let's get into the basics of preferred stocks.

This form of stock is a hybrid security that is a little like debt and a little like equity. Like common stock (which is what is most often bought and sold on the market), preferred stock can carry voting rights in the company, but like bonds, it has fixed cash payments that are made on a predetermined schedule.

That combination makes them very attractive to venture capitalists looking to invest in start-up companies, explains Michael Schill, professor of finance at the University of Virginia's Darden Graduate School of Business Administration. That's because preferred stockholders typically get promised payments yet with greater control on firm policy than that maintained by bond holders. Bond holders often find their voices ignored, he says.

Preferred share dividends are typically higher than the interest coupons on a company's bonds. And for that reason they often trade like bonds, moving down in price when interest rates go up (and up when rates fall). Those high "coupons," however, can give preferred stock higher equity-type returns overall.

That bigger return is in part compensation for the additional risk taken on by the investor, because in the event of bankruptcy, preferred holders only get paid if there is any money left after bond obligations are settled.

Before You Buy a Preferred Stock

Like "souped-up" sports cars, preferred shares all have basic similarities, but most are custom built. Even those issued by the same company can have different features. For that reason investors need to ask some important questions before buying.

The key questions are what is the maturity date, what is the so-called "yield-to-call," and how good is the credit quality, says Rob Brown, chief investment officer at Genworth ( GNW), an insurance and financial services company.

The maturity date of the debt is important because it tells you how long you can expect to receive dividend payments from the company, although that's not the whole story. It is also important to look at when or if the preferred is callable. A call feature gives the management the right to buy back the stock at face value after a certain date and tends to reduce the overall value of preferred stock. As a result investors need to watch the yield-to-call figure, which gives a more conservative estimate of likely returns.

The Risk and Reward of Preferred Stock

Because the preferred stock investors won't receive any payment in the event of a default or bankruptcy, the credit quality of the company is very important, he explains. Cautious investors may wish to stick with companies that have so-called investment grade ratings on their bonds.

Brown recommends allocating about 10% of a portfolio to preferred stock. He also notes that preferred stock may have specific tax advantages for investors since the dividends are frequently given favorable tax treatment.

Preferred stock may also include an option to convert into common stock. That option can be valuable to investors looking to benefit from the potential success of the company.

Details of companies' preferred stock can frequently be found on the investor relations section of their Web sites, or alternatively through commercial sites such as PreferredsOnline.

In your example, the Goldman site details that its series A, B and C preferred stocks are all perpetual issues, meaning that they can remain outstanding for as long as the company desires. It is worth noting, however, that the series-A is callable in April 2010, while the series-B and series-C each have call dates of October 2010. The series-D has a maturity date of February 2034.