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Preferred vs. Common Stock: An Overview
Many investors have heard of preferred and common stock. Both types of stock represent a fractional ownership in a company, and both are tools that investors can purchase to try to profit from the future successes of the business.
However there are differences between preferred and common stock that investors should understand. An important one is that preferred stock shareholders have priority over a company's income, meaning they are paid dividends before common stock shareholders. They are also paid first if a company is liquidated.
Preferred stock usually does not give shareholders voting rights. Common or ordinary stock does, usually at one vote per share owned.
Key Takeaways
- An important difference between preferred and common stock is that preferred stock shareholders have priority over a company's income, meaning they are paid dividends before common shareholders.
- Preferred shareholders are also given payment preference in a company liquidation.
- Preferred stock usually confers no voting rights to shareholders while common stock does.
- Common stock shareholders are last in line when it comes to company assets, which means they will be paid after creditors, bondholders, and preferred stock shareholders.
- Preferred stock is less volatile than common stock and is callable.
Preferred Stock
Bond-Like Aspects
Preferred stock is a type of security that shares characteristics of bonds and stocks. Like bonds, they provide investors with a predictable flow of income. That's because their dividends are determined when the stock is issued. At the same time, they represent ownership in a company and are traded on an exchange.
Preferred stock has a par value which is affected by interest rates. When interest rates rise, the value of the preferred stock declines, and vice versa. In addition, the price of preferred stock is normally less volatile than the price of common stock.
Preferreds also have a callability feature similar to bonds which gives the issuer the right to redeem the shares from the market after a predetermined time.
Investors who buy preferred shares have a real opportunity for these shares to be called back at a redemption rate that represents a significant premium over their purchase price. The market for preferred shares often anticipates callbacks and prices may be bid up accordingly.
In case of bankruptcy or liquidation, preferred stock shareholders have a priority claim on a company's assets and earnings. This is also true during the company's good times, when the company has excess cash and decides to distribute money to investors through dividends.
Dividends
As mentioned, preferred stock shareholders are paid their dividends before common stock shareholders (who may or may not receive dividends). If a company misses a dividend payment, it must first pay any arrears to preferred stock shareholders before paying common stock shareholders.
In addition, the dividends for preferred stock are usually higher than those for common stock.
The annual dividend per share is calculated by multiplying the dividend rate by the stock's par value. The dividend yield of a preferred stock is calculated by dividing the dollar amount of a dividend by the price of the stock.
Voting Rights
Preferred stock confers no voting rights. So when it comes time for a company to elect a board of directors or vote on any form of corporate policy, preferred shareholders have no voice about the future of the company.
Pros and Cons of Preferred Stock
Usually pays a set dividend
Volatility can be low
Offers income and some growth potential
Can be called away by issuers
No voting rights
If interest rates rise, price falls
One type of preferred stock, the perpetual preferred stock, guarantees a fixed dividend in perpetuity. Another type, convertible preferred stock, offers investors the opportunity to convert preferred shares into common stock.
Common Stock
Common stock represents shares of ownership in a corporation and a claim on profits. It is the type of stock in which most people invest. When people talk about stocks, they are usually referring to common stock. In fact, the great majority of stock is issued in this form. With common stocks, share value is determined by supply and demand.
Voting Rights
Common shares confer voting rights. Investors usually receive one vote per share owned. They vote to elect board members who oversee the major decisions made by management. Stockholders thus have the ability to exercise control over corporate policy and management issues.
Growth
Common stock tends to outperform preferred shares and offers the greater potential for long-term growth. If a company does well, the value of a common stock can go up. But keep in mind, if the company does poorly, the stock's value normally goes down.
Dividends
A company's board of directors decides whether or not to pay out a dividend to common stockholders. They are never guaranteed. In fact, many companies do not pay common stock dividends at all. If a company misses a dividend, the common stock shareholder gets paid after those holding preferred shares.
The claim on a company's income and earnings is most important during times of insolvency. In such a case, common stock shareholders are last in line for the company's assets.
This means that when the company must liquidate, it pays all creditors and bondholders first, then preferred shareholders, and finally, common stockholders.
Pros and Cons of Common Stock
Potential for high growth
Highly liquid
Voting rights
Volatility can be normal
Risk of dropping prices
May not receive dividends
The first common stock was issued by the Dutch East India Company in 1602.
Differences Between Preferred and Common Stock
| Preferred Stock | Common Stock | |
|---|---|---|
| Bond Similarity | Yes | No |
| Income Stream | A fixed dividend | May or may not receive dividends |
| Voting Rights | Usually none | Yes, usually one vote per share owned |
| Payment Priority | Senior to common stock shareholder | None |
| Growth Potential | Limited | Unlimited |
| Volatility | Less than common stock | Greater than preferred stock |
| Liquidity | Less liquid; may be hard to sell | Usually highly liquid |
Why Might Investors Seek Out Preferred Stock?
Investors might want to invest in preferred stock because of the steady income and high yields that they can offer, dividends that are usually higher than those for common stock, and their stable prices.
Which Offers More Growth Potential, Common or Preferred Stock?
Common stock offers greater potential growth in value because its price tends to move to a much greater degree. Capital gains are a greater possibility with common stock.
Which Is Riskier, Common or Preferred Stock?
Each has its risks. However preferred stock generally is seen as less risky because its price moves are less volatile and its shareholders are always paid dividends before common stock shareholders.
The Bottom Line
Preferred stock and common stock can both be attractive securities for investors. While preferred stock may offer a steady source of income compared to common stock, its share price normally has less growth potential.
Common stock shareholders get voting rights while shareholders of preferred stock normally do not. As a result, they can't influence company decisions concerning important matters such as the selection of board members, acquisitions, and stock splits.