Investors often purchase stocks because they are interested in dividend payments, capital appreciation, or the right to vote in a shareholder meeting. There are two main types of stock: preferred and common. Each offers unique benefits to stockholders. Depending on your individual investment goals, you may be more interested in one type of stock over the other.
Preferred vs. common stock
Common and preferred stock both represent a proportional share of ownership in a company, but you are entitled to different rights depending on which you invest in. Both preferred and common stocks can be sold or traded on an exchange.
A common stock is often the first to come to mind when discussing equities. It offers voting rights to shareholders and the issuer may choose to pay shareholders dividends. Generally, investors purchase shares of common stock for their ability to appreciate in value over time if the business is successful.
For instance, if a company issues both preferred and common stock and has an incredibly profitable year, the value of its common stock will shoot up, while its preferred value might only slightly increase.
A preferred stock pays stockholders set dividend payments on a regular schedule, but does not have voting rights or as high potential for capital appreciation as common stock. Investors tend to buy shares of preferred stock for their consistent income and lower financial risk if a company faces losses.
Now that we have the basics down, lets take a look at what makes a preferred stock different from a common stockand what makes them similar.
What are preferred stocks?
Preferred stocks pay a fixed dividend to shareholders, are prioritized in the event of bankruptcy, and are less impacted by market fluctuations than common stock.
Preferred stocks are typically purchased for its consistent dividend payments, which offer less financial risk to shareholders than common stock. Its important to note that dividend payments are not guaranteed. When businesses have enough profit to pay dividends, they prioritize preferred shareholders first, and then pay common shareholders if there are funds leftover.
This is also true in the case of insolvency. For instance, lets say a company goes bankrupt. Debt holders will get paid first, meaning all of the bondholders' interest payments have to be paid out first, says Patrick Bobbins, vice president financial advisor of Wealth Enhancement Group. Then the preferred equity would be paid second, and then common shares if the board decides to pay a dividend at the end.
Preferred shares have the ability to appreciate in value over time, but not nearly as high as common shares. This is because the value of a preferred stock is inversely tied to interest rates. If the interest rates decrease, the value of a preferred share will increase.
How preferred stocks work
Preferred stocks operate similarly to a bondit pays a fixed-income payment, has a par value, is callable, and can be issued with a maturity date, usually lasting 30 years or longer. Unlike a bond, preferred stock dividends are not guaranteed, so the issuer can skip out on paying dividends to preferred shareholders if the company is not profitable.
Par value: Preferred stocks are issued with a fixed par value, also known as the face value. This is the amount a shareholder would receive if they redeemed the stock by the issuer. This amount is typically around $25 and can range upwards of $1,000 for corporate securitiesbut these shares are generally geared towards larger institutional investors.
Call date: Issuers of callable preferred stocks give shareholders the right to redeem preferred stocks for a specific dollar amount, as stated in the prospectus, after a certain dateknown as the call date. Usually the payout is equal to the par value or a higher call price. This amount does not have to equal the initial price you paid to purchase the preferred stock.
Companies typically call stocks when interest rates are low, so they can reissue a new preferred stock with a lower dividend payment to match the current market rates. This prevents preferred stocks from appreciating in value as much as a common stock may be able to.
Dividend: A dividend is a fixed-payment that a shareholder receives from the issuer, usually paid each quarter. The issuer payout requirements depend on if the preferred stock is cumulative or non-cumulative.
In cumulative preferred stock, the issuer is required to pay preferred shareholders dividends from any missed payments, including those from previous years, before paying out common stockholders. This structure is common in real estate investment trusts (REITs).
In non-cumulative preferred stock, the issuer is not required to make up any missed payments, and does not incur any penalty for missing these dividends. Bank stocks typically have a non-cumulative structure.
There are several other types of preferred stocks. Here is a general overview of what they are and their individual differences.
Pros and cons of preferred stocks
Investors tend to favor preferred stocks because of the fixed-income payments, which are higher than that of common stocks on average, says Bobbins. Other benefits of owning preferred stock include a lower investment risk compared to common stocks.
On the downside, there is a limit on how much the investment can appreciate because of its call feature. Issuers often call preferred bonds in low-interest rate environments so they can reissue a stock that pays a lower dividend. Unlike common stocks, preferred stocks do not have voting rights.
What are common stocks?
Common stocks represent shares of ownership in a business and offer investors voting rights in the company, which allow them to vote on key business factors such as electing the board of directors.
These stocks aim to yield higher rates of return over long periods of time compared to preferred stocks. The value of common stock is tied to the business performance. For instance, if a business is extremely successful, the value of the company's common stocks will increase. Shareholders may choose to hold onto their shares in hopes of increasing their capital gains in the long-run, or may decide to sell their shares for a profit.
On the flipside, if a company performs poorly, the value of common stocks can decrease to $0. In the event of bankruptcy, preferred stockholders are prioritized to receive bankruptcy payouts before common stockholdersif there is not enough funds left, common shareholders may completely lose their initial investment.
Because a common stock is more volatile, it is considered a higher risk investment than preferred stocks. But, common stock also has the potential to accumulate capital appreciation in the long-run, which can significantly increase the investment value.
How common stocks work
Common stocks are issued by both private and public companies. During an initial public offering (IPO), a company will sell shares of their company ownership, including voting rights, in order to raise capital to fund their business ventures. After the IPO, shares of common stock can be sold or traded in the public markets on stock exchanges, through a broker, or directly from a company.
Voting rights: Common stocks give stockholders voting rights in shareholder meetings. This gives shareholders the right to weigh in on decisions like potential stock splits, mergers and acquisitions, dividend payments, and other topics that impact their shares.
But not all stockholders' votes are weighted equallythe number of votes you get depends on how many shares you own. Therefore, someone who owns a large percentage of the companys shares has a greater influence on voting matters than someone who owns only one or two shares. If a shareholder is unable to attend a meeting in person, they are still able to vote by proxy by sending their vote in the mail or allowing a third-party proxy to vote on their behalf.
Dividends: Companies are not required to pay dividends to common stockholders. However, if a company chooses to pay dividends, common shareholders do not receive any payments until all preferred shareholders have received their payment. If a company is unable to pay dividends in a particular year, common shareholders do not receive missed dividends.
Pros and cons of common stocks
Many investors prefer common stock because of its potential to earn long-term capital gains if the company is successful. But if the company does not perform well, common stocks are more vulnerable to financial losses.
In the event a company goes belly up, common stockholders are the last to be paid outif the company has any money left over after paying back their creditors, debtholders, bondholders, and preferred stockholders that is.
How to choose between the two
If you are considering investing in stocks, you should carefully review the key factors of both common and preferred stock before purchasing.
Voting rights: Common stocks offer stockholders the opportunity to vote in company shareholder meetings on factors that impact their stock ownership. Preferred stockholders give up this right in exchange for consistent dividend payouts.
Investment horizon: Investors with a long-term investment horizon often favor common stocks because of their ability to significantly increase in value over time if a company is successful. On the flipside, investors with short-term financial needs may be more inclined to own preferred stock because of its steady dividend income.
Risk tolerance: Common stocks are considered a riskier investment because of their tendency to fluctuate in value. Additionally, if a company goes bankrupt, common shareholders receive their payout lastif they receive anything at all.
Preferred stocks are less volatile and therefore have lower capital loss risk. In the event of insolvency, preferred stockholders have a higher priority to receive payments over common stockholders.
At the end of the day, both preferred and common stocks are an investment security which comes with additional risks including investment risk, interest rate risk, and capital risk. You should carefully consider your long-term financial and investment goals before purchasing shares of a company.
