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Preferred vs. Common Stock: An Overview
Both preferred and common 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. There are significant differences between them, however. An important difference is that preferred stock shareholders have priority over a company’s income. They’re paid dividends before common stock shareholders. They’re also paid first if a company is liquidated.
Preferred stock usually doesn’t 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 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 but common stock does.
- Common stock shareholders are last in line when it comes to company assets. They’re paid after creditors, bondholders, and preferred stock shareholders.
- Preferred stock is less volatile than common stock and it’s callable.
Preferred Stock
Preferred stock is a type of security that shares characteristics of bonds and stocks. They provide investors with a predictable flow of income like bonds do because their dividends are determined when the stock is issued. They represent ownership in a company and are traded on an exchange.
Bond-like aspects
Preferred stock has a par value that’s affected by interest rates. When interest rates rise, the value of the preferred stock declines and vice versa. The price of preferred stock is normally less volatile than the price of common stock.
Preferreds also have a callability feature similar to bonds that 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.
Preferred stock shareholders have a priority claim on a company’s assets and earnings in the case of bankruptcy or liquidation. This is also true during the company’s good times when it has excess cash and decides to distribute money to investors through dividends.
Dividends
Preferred stock shareholders are paid dividends before common stock shareholders who may or may not receive dividends. A company must first pay any arrears to preferred stock shareholders before paying common stock shareholders if it misses a dividend payment.
The dividends for preferred stock are usually higher than those for common stock as well. 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. Preferred shareholders have no voice in the future of the company when it comes time for a company to elect a board of directors or vote on any form of corporate policy.
Pros and Cons of Preferred Stock
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Can be called away by issuers
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No voting rights
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If interest rates rise, price falls
Important
A type of preferred stock known as the perpetual preferred stock guarantees a fixed dividend in perpetuity. A 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’s the type of stock in which most people invest. The great majority of stock is issued in this form. 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 can therefore exercise some control over corporate policy and management issues.
Growth
Common stock tends to outperform preferred shares and offers a greater potential for long-term growth. The value of a common stock can go up if a company does well but the stock’s value normally goes down if the company does poorly.
Dividends
A company’s board of directors decides whether to pay out dividends to common stockholders. They’re never guaranteed. Many companies don’t pay common stock dividends at all. The common stock shareholder gets paid after those holding preferred shares if a company misses a dividend.
The claim on a company’s income and earnings is most important during times of insolvency. Common stock shareholders are last in line for the company’s assets in this case. The company pays all creditors and bondholders first, then preferred shareholders, and finally common stockholders when the company must liquidate.
Pros and Cons of Common Stock
Fast Fact
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 |
Use This in Real Life
Let’s say you have a choice between investing in preferred stock or common stock of a company you have your eye on. Which is the best option for you? It can all come down to your investment goals and your personal concerns.
Is your financial position such that some periodic payments might be appreciated? You might be better off with preferred stock in this situation because the company will pay dividends.
Do you have a stake in the company, emotionally or otherwise, so you want some control over certain aspects of its management? Common stock might be right for you in this case.
How’s your risk tolerance? You’d most likely be more comfortable with preferred stock if you don’t tolerate volatility well and want to ensure that you’re paid first before common stock shareholders in the event of a worst-case scenario liquidation.
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, because dividends are usually higher than those for common stock, and for 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 but preferred stock is generally seen as less risky because its price moves are less volatile. 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. Preferred stock may offer a steady source of income compared to common stock but its share price normally has less growth potential.
Common stock shareholders get voting rights while shareholders of preferred stock normally do not. They therefore can’t influence company decisions concerning important matters such as the selection of board members, acquisitions, and stock splits.
