When evaluating investment options, most investors would agree that understanding the differences between preferred and common stock is critical for making informed decisions.
In this post, I will clearly outline the key distinctions between preferred and common stock to help you determine which is better suited for your financial objectives.
You will learn about ownership rights, voting privileges, dividend payments, risk profiles, and more. I will also provide real-world examples to demonstrate when each stock type makes the most sense based on an investor's priorities and risk tolerance.
Introduction to Preferred vs Common Stock
This section will provide an overview comparing preferred stock and common stock, focusing on key differences in ownership rights, dividend payments, and risk.
Understanding the Capital Structure: Preferred Stock and Common Stock
Preferred stock and common stock are two main types of stock companies issue to raise capital.
Preferred stock has features of both equity and debt. Like bonds, preferred shares have a stated dividend yield and par value. However, like common stock, preferred shares represent an ownership stake in the company. Key features include:
- Fixed dividend yield, paid before common stock dividends
- Higher claim to assets and earnings than common shares
- Less voting rights than common shares
- Less potential growth than common shares
Common stock represents basic ownership in a company. Key features include:
- Voting rights to elect the board of directors
- Rights to profits through dividends and capital appreciation
- Lower priority claim to assets versus creditors and preferred shareholders
- Higher risk than preferred shares but more upside potential
Comparing Ownership and Voting Rights: Vote on Proxies, Elect Board Members
Preferred shareholders usually have very limited voting rights, while common shareholders control most voting rights.
Preferred shareholders may be granted rights to vote on certain corporate changes that could affect their interests. But in most cases, they do not vote for the board of directors or vote on normal proxies.
Meanwhile, common shareholders exercise majority control through voting rights. They elect the board of directors, vote on management compensation, and approve major transactions.
So while preferred shares offer more security and predictable income streams, common shares offer more control and influence on corporate governance.
Dividend Yields and Payments: A More Secure Dividend for Preferred Stocks
Preferred stock dividends are set at time of issue as a percentage of par value. Most preferred dividends are cumulative, meaning the company must pay them before common stock dividends.
For example, a preferred stock with 5% dividend yield and $100 par value guarantees a $5 annual dividend per share. If unpaid, these dividends accumulate as arrears and must be paid before common shareholders receive dividends.
In contrast, common stock dividends vary over time based on earnings and cash flow. They receive lower priority than preferred dividends. During periods of weak profits, common stock dividends may be reduced or suspended while preferred dividends continue at fixed rates.
So preferred shareholders generally receive more consistent dividend streams, while common shareholders experience higher long-run total returns through rising profits and stock prices over time.
What is better common stock or preferred stock?
Preferred stock typically offers more security and stable dividend payments compared to common stock, making it lower risk in some ways. However, common stock offers other potential benefits. Here is a comparison of some of the key differences:
Security
Preferred stock is generally considered less risky than common stock for a few reasons:
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Preferred shareholders have priority if the company goes bankrupt. They get paid back before common shareholders.
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Preferred stocks have a more secure dividend. Companies are obligated to pay dividends on preferred shares before common shares.
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However, there is still risk. The company can suspend preferred dividends if in financial trouble.
Potential Growth
Common stocks generally have higher growth potential than preferred stocks:
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Common stocks benefit more from company growth. Their value can rise faster since preferred stocks have a fixed dividend.
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Common shareholders can vote on company matters while preferred shareholders usually cannot. This gives common shareholders more control.
Dividends
Preferred stocks generally offer higher dividend yields than common stocks:
- Preferred stocks tend to have higher and fixed dividend rates set when issued. Common dividends vary based on company performance and payout policies.
So in summary, preferred stock is lower risk and offers more secure dividends, while common stock has higher growth potential and voting rights. Investors should weigh their risk tolerance against desire for higher but variable returns.
Why would a company issue preferred shares instead of common shares?
Companies may choose to issue preferred shares instead of common shares for a few key reasons:
Stability and preferred status
Preferred shares offer more stable dividends that must be paid before common share dividends. They also have preference over common shares in bankruptcy liquidation. This makes preferred shares lower risk and more appealing to conservative investors.
Avoid diluting control and voting rights
Issuing additional common shares dilutes the ownership and voting power of existing shareholders. Preferred shares allow raising equity capital without diluting control or voting rights concentrated in common shares.
Callability
Companies can redeem or buy back preferred shares at their discretion. This allows retiring them when cheaper financing sources become available. Common shares do not have this callable feature.
Overall, preferred shares offer advantages like predictable dividends, senior status, and flexible redemption. These make them useful for raising capital from investors who prioritize stability over voting power and upside potential. Companies strategically balance preferred and common shares to meet funding needs while optimizing their capital structure.
What is an example of a preferred stock?
An example of preferred stock is a company issuing a 7% preferred stock with a $1,000 par value per share. In this case, investors would receive a $70 annual dividend per share, paid out at $17.50 per quarter.
Some key features of this preferred stock example include:
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7% Dividend Yield: Investors earn $70 per year in dividends for every share they own. This equals a 7% dividend yield based on the $1,000 par value.
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$1,000 Par Value: This is the face value per share that preferred stocks are issued at. The par value does not change over time.
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Fixed Dividends: The 7% dividend payments are fixed and do not fluctuate, providing more stable income than common stocks.
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Priority Over Common Stocks: Preferred shareholders get paid dividends before any are paid to common shareholders.
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Limited Upside: While preferred stocks have more secure dividends, they give up the unlimited upside potential of common stocks in exchange.
So in summary, this 7% $1,000 par preferred stock offers investors a consistent 7% annual return through fixed dividend payments. While they give up the potential price appreciation of common stocks, preferreds provide reliable income without as much price volatility.
Why would a company convert preferred stock to common stock?
A company may choose to convert preferred shares into common shares for a few key reasons:
Flexibility in paying dividends
With preferred shares, companies are obligated to pay dividends at a fixed rate before paying dividends to common shareholders. By converting preferred to common, companies gain more flexibility in allocating profits and can provide higher returns to all shareholders when business is good, without the obligation to pay preferred dividends when business is bad.
Access to increased earnings
Over time, common stock dividend yields may rise above the fixed preferred stock dividend rate. Converting gives preferred shareholders the potential to enjoy higher returns from the company's success.
Simplified capital structure
Converting preferred to common simplifies the company's capital structure into one uniform class of stock. This streamlines voting and makes the stock more accessible to retail investors, potentially increasing demand.
Reduce administrative costs
Since preferred shares carry special rights and dividend payments, they incur higher administrative costs related to tracking ownership privileges, sending dividend payments, and maintaining separate records. Converting them to common shares simplifies record-keeping and reduces these recurring expenses.
In summary, converting preferred to common stock trades obligations and fixed returns for flexibility and higher potential earnings. It can benefit both the company and shareholders when business growth outpaces preferred dividend rates.
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Deciphering the Difference Between Common Stock and Preferred Stock
Common stock and preferred stock have some key differences that investors should understand.
Risk Considerations: Preferred Stock as a Safer Investment
Preferred stock is generally considered less risky than common stock for a few reasons:
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Preferred shareholders have priority over common shareholders for dividend payments and assets in the event of liquidation. This gives preferred stock more security.
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Preferred dividends are typically set at a fixed rate and are more reliable than common stock dividends, which may fluctuate widely or be eliminated. This predictability reduces risk.
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While common stock prices swing widely, preferred shares tend to be stable as they have a par value and liquidation preference that helps anchor their price.
So while preferred stock lacks the high growth potential of common shares, preferreds carry significantly lower risk.
Market Value Fluctuations: Par Value vs Market Trends
Preferred stock differs from common stock in how its price is determined:
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Common stock is valued based purely on market trends and investor demand. Its price can fluctuate dramatically.
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Preferred shares trade close to their par value rather than based on market whims. Their liquidation value also puts a floor under their price.
So common shares offer more upside and downside price potential, while preferred prices hold steadier near their stated par value.
Tax Implications: Understanding Dividends Taxation
There are also tax differences in dividends from preferred versus common shares:
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Preferred stock dividends are typically taxed at a higher rate than qualified common stock dividends.
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But preferred dividends also offer more tax deduction benefits for corporations than common dividends.
So weighing the different tax implications is important when evaluating preferred and common shares.
In summary, while common and preferred stock have similarities, their differences in risk, valuation, dividends, and tax treatment can be significant for investors. Doing research before investing is key.
Exploring Types of Preferred Stock
Preferred stock represents an ownership stake in a company that comes with certain rights and preferences over common stock. There are several types of preferred stock to be aware of:
Cumulative Preferred Stock: Protecting Dividend Rights
Cumulative preferred stock guarantees dividend payments that accumulate over time if they are unpaid. For example, if a cumulative preferred stock has a $1 per share dividend but the company misses payments over 2 years, those missed $2 payments per share would need to be paid before common stock dividends can resume. This protects preferred shareholders.
Callable Preferred Stocks: Issuer's Right to Redeem
With callable preferred stock, the issuing company has the right to repurchase or redeem the shares at a call price after a certain date. This allows the company to refinance the shares under more favorable terms if market rates decline. However, it introduces reinvestment risk for investors if shares are called in a rising rate environment.
Convertible Preferred Stock: Blending Equity and Fixed Income
Convertible preferred stock can be exchanged for a specified number of common shares, usually at the investor's discretion. This allows investors to gain upside if the common stock rises while getting priority over common dividends. However, conversion terms introduce complexity when valuing shares.
In summary, preferred stocks have tradeoffs to consider versus common stocks or bonds. Understanding the various preferred stock structures enables informed investment decision making aligned with one's objectives and risk tolerance.
Preferred Stock vs Common Stock Pros and Cons
Dividend Priority and Payment Security
Preferred shareholders have priority over common shareholders when it comes to receiving dividend payments. This means companies must pay dividends to preferred shareholders before distributing any dividends to common shareholders. As such, preferred stocks offer more security and reliability with dividend payments. However, the tradeoff is that preferred stocks generally have a fixed dividend amount that does not increase over time.
Capital Appreciation Potential of Common Stocks
Common stocks offer the potential for price appreciation and capital gains. As a company grows and becomes more profitable, the market value and share price of its common stock tends to increase as well. So common shareholders have the opportunity to realize substantial returns if the stock price rises significantly over time. However, common stocks also carry higher risk - if a company falters, common shareholders are last in line to recoup any value or assets in the case of bankruptcy.
Fixed Interest Rate vs Variable Dividends
Preferred stocks pay a fixed dividend amount, expressed as a percentage yield based on the stock's par value. This provides stable income at a defined rate. In contrast, common stocks pay dividends that may vary over time along with the company's financial performance and payout policy. During growth periods, common stock dividends can increase and offer robust yields. But they can also be reduced or suspended if a company experiences financial troubles. So common stock dividends are less reliable than the fixed dividend yields of preferred stocks.
Real-world Preferred Stock vs Common Stock Examples
Initial Public Offering: Choosing the Right Class of Stock
When a company first goes public through an initial public offering (IPO), it will typically only issue common stock. Common stock allows the founders and early investors to retain control of the company while raising additional capital from public investors.
Since an IPO represents a speculative investment in an unproven company, investors are taking on higher risk. Common stock provides unlimited upside potential to compensate for this risk. Preferred shares with a fixed dividend would limit investors' return.
Established Corporations and Shareholders' Equity
For mature public companies, issuing preferred stock allows them to raise capital without diluting the common shareholders' ownership and voting rights. The company can structure preferred shares to have a senior claim on assets and earnings over common stock.
Reasons an established corporation may issue preferred shares include:
- Raising capital while avoiding common stock dilution
- Adjusting their capital structure to have more stable earnings for debtholders
- Appealing to income-focused investors with preferred dividends
The preference makes preferred shares lower risk than common for investors in stable corporations. The senior claim on assets and fixed dividends compensates for reduced upside potential.
Investment Strategies: Income vs Growth Objectives
Income Investors
Preferred stock suits income investors better since it pays reliable dividends and has seniority over common stock. The fixed dividend payout provides stable investment income.
Growth Investors
Common stock matches growth investors' priorities to maximize capital appreciation over time. While common stock dividends can grow over time, income is secondary to share price gains for these investors. The unlimited upside potential of common shares outweighs the risk for those with long investment horizons.
In summary, preferred stock meets income investors' needs for stability and cash flow. Common stock better serves growth investors pursuing share price appreciation despite higher risk. An investor's financial objectives help determine which type of stock reaches their goals.
Preferred Stock vs Common Stock in Table Form
| Category | Preferred Stock | Common Stock |
|---|---|---|
| Ownership Stake | Preferred shareholders have partial ownership rights but usually no voting rights. They have higher priority to assets/dividends but lower growth potential. | Common shareholders have voting rights and greater influence over management decisions. They have higher growth potential but lower priority to assets/dividends. |
| Voting Rights | Preferred shareholders usually cannot vote on company matters or elect board members. | Common shareholders can vote on company matters and elect board members. |
| Proxy Voting | Preferred shareholders cannot usually vote by proxy. | Common shareholders can vote on proxies. |
| Dividends | Preferred shareholders get paid dividends before common shareholders. Dividends are usually set at a fixed rate and are more reliable. | Common shareholders are not guaranteed dividends. Dividend payments depend on company profits and cash flow. |
| Payment Priority | Preferred shareholders have a higher priority on dividend payments and claims to assets in case of liquidation. | Common shareholders have lower priority on dividends and assets. Preferred shareholders get paid first. |
Ownership Stake in the Company: Equity Comparison
Preferred shareholders have a partial ownership stake in the company, but usually without voting rights or influence over management decisions. Their ownership rights take priority over common shareholders in case of liquidation or bankruptcy, but they do not participate in the upside growth potential of common stocks.
Common shareholders have voting rights and greater influence over company management and policies. They elect the board of directors and vote on major decisions. Their ownership stake gives them a claim to future profits and appreciation in the stock price, providing higher long-term growth potential. However, common shareholders have lower priority to assets and dividends relative to preferred shareholders.
So in summary, preferred shareholders have less risk exposure and higher income stability from fixed dividend yields, while common shareholders have greater influence and upside but more risk.
Voting Rights and Proxy Votes: Shareholder Influence
Preferred stock usually does not come with voting rights attached. Preferred shareholders cannot vote on company matters like electing the board of directors or voting on mergers and acquisitions. They also lack the right to vote by proxy on management proposals.
In contrast, common stockholders can exercise voting rights on major company decisions and cast votes to elect the board of directors who oversee management. Common shareholders can also vote by proxy on management proposals without attending shareholder meetings in person.
This gives common shareholders greater influence over company policies, CEO pay, corporate strategy, and other governance matters. However, preferred shareholders often have priority ahead of common shareholders when it comes to dividend payouts and claims on company assets. So there is a tradeoff between influence and income stability.
Dividend Yields and Payment of Dividends: Stability vs Growth
Preferred stock offers reliable dividend payouts with yields based on a fixed percentage or dollar amount. The issuing company is obligated to pay preferred stock dividends before making any common stock dividend payments. This gives preferred shareholders priority access to income, making their dividends comparatively stable and secure.
In contrast, common stock dividends are variable and tied to the company's financial performance and cash flows. Common stock dividend yields are generally lower but offer higher capital appreciation potential from stock price gains. Companies are not required to pay common stock dividends, but have more flexibility to increase payments over time as the business grows and generates larger profits.
So in determining between preferred vs common stock, weigh the income stability from fixed preferred stock dividends against the growth potential and influence offered by common shares.
Conclusion and Summary
Preferred stock and common stock offer investors different risk-reward profiles. Preferred shares tend to provide more stable dividends and greater security, while common stocks offer higher growth potential but less guaranteed returns.
Final Takeaways: Choosing Between Preferred Shares and Common Stocks
When deciding between investing in preferred or common shares, consider:
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Income vs Growth - Preferred stocks pay reliable dividends, while common stocks offer higher capital appreciation potential.
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Risk Tolerance - Preferred shares carry lower risk as they have priority over common stocks for dividends and claims on assets.
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Voting Rights - Common shareholders typically have voting rights while preferred shareholders often do not.
Investment Considerations: Balancing Risk and Reward
Ultimately both preferred and common stocks have a role, depending on an investor's financial situation and goals. Preferred shares provide steady income for conservative investors, while common stocks present higher risks but also higher potential rewards. Maintaining a balanced portfolio with both classes of shares can allow investors to enjoy stable dividend income as well as participate in the growth of dynamic companies.
