How Does Preferred Stock Differ From Common Stock?

Companies issue stock to raise capital, representing fractional ownership. Different types of stock come with varying rights and privileges. Understanding these distinctions is important for investors, especially the differences between common and preferred stock.

Understanding Common Stock

Common stock is the most prevalent type of equity security and represents residual ownership in a corporation. Holders of common stock typically possess voting rights, allowing them to influence corporate matters such as the election of board members and major company decisions. Each share generally corresponds to one vote, meaning investors with more shares have greater voting power. Dividends for common stock are not guaranteed and can fluctuate based on the company’s profitability and discretion of its board of directors. These dividends are paid only after obligations to creditors and preferred stockholders have been met.

The primary appeal of common stock often lies in its potential for significant capital appreciation, where the share price increases over time as the company grows. In the event of a company’s liquidation, common stockholders are at the bottom of the priority list. They receive any remaining assets only after all creditors, including bondholders, and preferred stockholders have been paid. This position makes common stock a riskier investment in scenarios of financial distress or bankruptcy.

Understanding Preferred Stock

Preferred stock is a hybrid security, blending characteristics of both stocks and bonds. It often appeals to investors seeking a more stable income stream. Preferred stock typically pays a fixed dividend, similar to interest payments on a bond, which is usually stated as a percentage of its par value. A notable feature of preferred stock is that these dividends are often cumulative. If a company misses a dividend payment, the unpaid amount accumulates and must be paid to preferred stockholders before any dividends can be distributed to common stockholders.

While preferred stock offers this dividend preference, it generally does not come with voting rights in corporate matters. During liquidation, preferred stockholders have a higher claim on a company’s assets than common stockholders, although they are subordinate to creditors and bondholders. This preferential treatment provides a layer of security. Some preferred stocks also include features like callability, allowing the issuing company to repurchase the shares, or convertibility, which permits shareholders to exchange preferred shares for a predetermined number of common shares.

Key Differentiating Features

The distinctions between common and preferred stock are evident when examining their core features. Common stockholders typically have voting rights, enabling them to exert influence on corporate matters such as the election of board members and major corporate actions. In contrast, preferred stockholders generally do not possess voting rights, or their voting rights are limited to specific extraordinary events, such as mergers or amendments to corporate charters. Dividend payments also highlight a significant difference. Preferred stock usually offers fixed, regular dividend payments that take precedence over common stock dividends. If a company faces financial difficulties, preferred shareholders must receive their dividends first, including any missed cumulative dividends, before common stockholders receive anything. Common stock dividends are variable, not guaranteed, and paid only after preferred dividends are satisfied.

In terms of asset claims during liquidation, preferred stockholders hold a superior position to common stockholders, paid out before them but after debt holders. Common stockholders are last in line, potentially receiving little to nothing. The potential for capital appreciation varies significantly. Common stock offers greater potential for capital gains as its share price can increase substantially with company growth. Preferred stock typically has less potential for significant capital appreciation, being more stable and less volatile, sometimes behaving more like a bond. This difference impacts their risk profiles; common stock carries higher risk due to volatility and lower liquidation priority, while preferred stock is generally less risky due to stable dividends and preferential claims. Some preferred shares also have features like callability or convertibility, which are not characteristics of common stock.

Investor Considerations

The differences between common and preferred stock cater to varying investor objectives and risk tolerances. Investors primarily seeking income often find preferred stock attractive due to its fixed and typically more reliable dividend payments. This steady income stream can be particularly appealing for those depending on regular distributions from their investments. Conversely, investors focused on capital appreciation and long-term growth potential often gravitate towards common stock. While common stock dividends are variable, the potential for significant increases in share price over time offers a different type of return, aligning with a growth-oriented strategy.

Risk tolerance also plays a significant role. Preferred stock, with its higher liquidation priority and stable dividends, may suit more conservative investors who prioritize capital preservation and consistent payouts. Common stock, with its greater volatility and lower claim on assets, is generally better suited for investors with a higher risk tolerance who are willing to accept greater fluctuations for the possibility of higher returns. Preferred stock prices may be more sensitive to interest rate changes, similar to bonds, while common stock prices are more influenced by overall company performance and market sentiment.