Common Stock vs Preferred Stock
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Whenever you buy some stock in a company, you are buying partial ownership in that company – literally.
Generally, publicly and privately-owned companies offer two kinds of stock purchases: common stock and preferred stock. Both kinds of stock indicate partial ownership of a company, but they come with different benefits and privileges.
Depending on your financial situation, it could be worthwhile to invest in both kinds of stock. We are going to talk about the difference between common and preferred stocks, how they affect your investment profile, and when it is ideal to invest in common or preferred stocks.
Common stocks are the regular stock shares that get sold on the market every day. The majority of stock ownership is in common stocks and there is a lot more common stock up for trading than preferred stock. Some companies only issue common stock to shareholders.
Since common stock comes with partial ownership, common stockholders usually have the right to vote on members of the board of directors and have a say in major corporate decisions. Common stockholders are also entitled to a share of a company’s profits, which are paid out in dividends. Most firms pay shareholders dividends on a quarterly basis.
The one major advantage common stocks have over preferred stocks is the capacity for unlimited growth. As a company grows, the value of their common stocks can rise dramatically. For example, Apple’s common stocks in mid-2006 were a paltry $9.00 per share. Now, as of the time of writing, Apple’s common stock value is a whopping $318.40 per share.
Think of the growth this way: If you invested $50,000 in Apple in 2006, that investment would currently be worth around $1.7 million—an astounding 3,400% profit. This extremely high growth potential of capital gains is one reason why most investors trade in common stock.
Common stock growth potential can be a double-edged sword though. Just as the price can rise, it can fall. Common stock value can fall to $0 and you can lose a part of or your entire investment if the company does not do well or has a bad quarter.
Common stockholders also get the lowest priority for dividend payouts. Creditors and preferred stockholders get paid first, then what is left gets divided up among common stockholders.
Common stockholders are also not guaranteed any dividend payouts at all. If the company does not have enough revenue to cover creditors, preferred stockholders, and common stockholders, then common stocks get no dividend payout.
Most of the time, companies just sell one kind of common stocks, but some might offer different types of common stocks with different payout figures and voting privileges.
- Virtually unlimited growth potential
- Come with company voting rights
- Preferred ownership
- Great for long-term growth investors
- Share price volatility
- Variable dividend payouts
- Lowest priority
Preferred stock and common stock share many features. Both indicate ownership in a company, the value of both can rise and fall depending on a company’s performance, and both are traded through brokerage firms.
One of the biggest differences between the two is that preferred stockholders generally do not have company voting rights. This means that preferred stockholders normally do not get a say in big company decisions or appointing members of the board of directors.
Preferred stock also pays dividends like common stock. The main difference is that preferred stocks pay a pre-agreed dividend amount.
This amount is fixed, unlike common stock dividends which change depending on how profitable the company is. Preferred stockholders have priority over common stockholders when it comes to dividend distribution.
The dividend payout for preferred stock is based on the par value of preferred stock. The dividend yield is usually calculated as a percentage of the market price. This is unlike common stocks in which dividend payouts are determined by the board of directors and are not guaranteed.
In some ways, preferred stocks are like bonds. The value of preferred stocks can change based on interest rates and preferred stocks have a “par value” which they can be converted to. Both bonds and preferred stocks can be repurchased by the seller after a period of time.
The difference between preferred stock and bonds is that bonds are less risky and have lower interest payments. Preferred stocks are a bit riskier than bonds, but have the potential for higher dividend payouts. Common stocks are riskier than both preferred stocks and bonds, but common stocks have the highest growth potential.
Since preferred stocks generate a high and stable dividend-yield, they are a good choice for dividend investors who want a stable income. Preferred stockholders get the first pick of dividend payouts to shareholders. So if a company misses a dividend payout, the preferred stockholders must be compensated before common stockholders are.
Lastly, some companies give investors the option to convert their preferred stock into a fixed amount of common shares. Common stockholders do not have the option to trade in common shares for preferred shares.
Cumulative and Non-cumulative
Dividends from preferred securities can be either cumulative or non-cumulative. In general, cumulative securities generate an obligation of the issuer in the case of missed dividend payments. These missed payments add up and the issuer is obligated to pay this cumulative amount before giving any dividends to common stockholders.
In contrast, with non-cumulative preferred securities, there is no obligation for the issuer to reimburse preferred shareholders for missed dividend payments. There are several other kinds of preferred stock agreements with complex payment terms. This is one reason why preferred stocks are pretty rare; they have weird payment terms that can be hard for inexperienced investors to navigate.
- High dividend yields and payouts
- Grants priority in the distribution of company assets
- Less volatile to market forces
- Good for high-yield dividend investors
- Higher gain than bonds
- Lower potential for growth than common stocks
- More sensitive to interest rates
- Upside potential is usually limited to redemption value
Why Do Companies Issue Preferred Stock at All?
Companies rely on all kinds of ways to finance upcoming projects or raise money to expand. Stocks and bonds are two types of funding mechanisms companies use. The main reason why companies issue preferred stock is because investors want them.
Investors are attracted to preferred stock because they can generate consistent dividend payments and have lower maturity rates than bonds. Preferred shareholders also like having their interest prioritized over those of common stockholders. Investors also value preferred shares because of their relative stability.
Corporations value preferred shares for two major reasons: Preferred stocks are a good way to finance projects without worrying about shareholder control and debt obligations that arise from bond agreements.
Since preferred shareholders generally do not have company voting rights, issuing preferred stocks is a good way for corporations to raise finances without having to worry about shareholders upsetting corporate organization and structures. Companies that want to limit shareholder control while still giving equity options might turn to preferred stock as an alternative.
Preferred stocks can also be used to lower a company’s debt-to-equity ratio. Since preferred stocks indicate partial ownership, any missed payments are an equity issue, not a debt issue.
Bond-debt can be a red flag for investors as bonds have very strict payment schedules that must be met no matter how well a company is doing. Preferred stocks are more flexible and don’t have such strict payment schedules, so if companies miss dividend payments, they can postpone payments to a later time.
Here is a quick fun fact too: The very first preferred stocks in the US were granted by infrastructure companies in Maryland in 1836. These companies issued preferred stocks as an alternative way to raise funds despite the poor shape and management of the companies.
Should I Invest in Preferred Stock?
To be completely honest, investing in preferred stock does not make much sense for an individual investor. Unless you have a very specific investment strategy that is explicitly based on high dividend-yield stock, then the majority of your portfolio stock should be common stocks.
Preferred stocks can be a goldmine for big company portfolios. Companies in the US are only required to pay taxes on 30% of their income from preferred dividends, which means that a whopping 70% of that amount is virtually tax-free. Individual investors can not really benefit from this tax-exemption unless they are particularly wealthy.
If you are looking for a stable long-term investment plan other than common stocks, then corporate bonds might be your best bet. When interest rates are attractive, individual investors might have a higher after-tax yield by investing in corporate or municipal bonds than they would from buying individual preferred stock.
Bonds also have the highest priority in terms of the distribution of corporate assets. Companies are legally obligated to pay bondholders first before preferred and common stockholders.
That being said, if you play your cards right then investing in preferred stock can be a good idea. A good mixture of preferred stock in your portfolio can give a reliable stream of income that can serve as an emergency fund in case your other investments don’t do so well.
If you are looking at purchasing some preferred stock, make sure to consider the following features:
First, check and see if the payment periods, rates, and terms are fixed or adjustable rates. Some preferred securities agreements let the issuer skip payment entirely so make sure you know how much you should be getting paid and when. This includes whether the preferred security is cumulative or non-cumulative.
A lot of preferred securities have a maturity date but many do not. Even if there is a maturity date, there is often the option to extend this date as much as you want.
Depending on the kind of preferred security, many issuers reserve the right for condition redemption of the issuer to redeem securities prior to their maturity date. Securities with call features might be less appropriate for investors who want preferred stocks for stable dividend payments.
Preferred dividends can be considered qualified and be taxed at capital gains rates, or they can be non qualified and be taxed as ordinary income. Make sure you know how taxation on these securities works.
Some preferred stock issuers give holders the option to convert preferred stock into a fixed amount of common shares. Usually, there are specific rules about when and how preferred stocks can be converted into common stock and these rules differ based on the issuer. Convertible preferred securities also might be more responsive to market changes than nonconvertible preferred stocks.
High dividend yields are one of the main reasons investors invest in preferred stock. Most of the time, preferred stock dividend yields are calculated by dividing the annual dividend payment by the current market value of a share.
Let’s sum up what we covered:
- Preferred stocks and common stocks both indicate ownership in a company
- Common stock grants shareholders voting rights while preferred stocks do not
- Preferred stocks generate a fixed dividend amount and have higher priority than common stocks
- Preferred stocks are more stable but have lower growth potential than common stocks
- Preferred stocks have many features of corporate bonds
- Preferred stocks can be cumulative or noncumulative
In general, preferred stocks are the best for dividend investors who want a steady and reliable stream of income. In general, your investment portfolio should consist mostly of common stocks but a selection of preferred stocks can insulate you from harm in the case that other investments don’t go so well.