What Are the Differences Between Common and Preferred Stock?

Stocks represent ownership stakes in a company, allowing investors to participate in its potential success and growth. Common stock and preferred stock are the two primary types. While both signify a form of equity, they come with distinct rights and characteristics that differentiate their appeal. Understanding these differences is essential for navigating the stock market effectively.

Voting Rights

Common stockholders typically possess voting rights, which allow them to influence corporate decisions and elect the board of directors. These rights empower common shareholders to have a say in major corporate actions, such as mergers, acquisitions, and changes to company policy, often on a one-vote-per-share basis. This participation provides common stockholders with control and oversight over the company’s management and strategic direction.

In contrast, preferred stockholders generally do not have voting rights, or their voting rights are significantly limited. They typically cannot vote on matters like electing board members or approving corporate policies. Their involvement in company governance is usually restricted to specific circumstances that directly impact their preferred shares, such as a default on dividend payments or changes to the terms of their stock. This means preferred shareholders have less direct influence over the company’s operational and strategic decisions compared to common shareholders.

Dividend Distributions

For common stock, dividends are discretionary and not guaranteed. Companies pay common stock dividends out of their profits, and the amount often fluctuates based on the company’s financial performance and the board of directors’ decision. These dividends can be paid in cash or sometimes as additional shares, typically on a quarterly or annual basis. The board can choose to reduce, suspend, or even eliminate common stock dividends if the company’s performance falters or if funds are needed for reinvestment.

Preferred stock typically offers fixed dividend payments that are usually expressed as a percentage of the stock’s par value. These dividends have priority over common stock dividends, meaning preferred shareholders must receive their payments before any dividends can be distributed to common stockholders. This preferential treatment provides a more predictable and stable income stream for preferred shareholders, similar to interest payments on a bond.

Preferred dividends can be cumulative or non-cumulative. Cumulative preferred stock requires any missed dividend payments to accumulate and be paid out in full before any dividends can be issued to common stockholders. If a company faces financial difficulties and skips a dividend payment, that missed payment becomes an “arrearage” that must be settled later. For instance, if a company misses two years of dividends on cumulative preferred stock, it must pay those two years’ worth of dividends, plus the current year’s dividend, before common shareholders receive anything.

Conversely, non-cumulative preferred stock does not accrue missed dividends. If the board decides to skip a dividend payment for non-cumulative preferred shares, that payment is permanently lost to the shareholder and does not need to be made up later. While non-cumulative preferred stock still has priority over common stock for current dividends, the absence of the accumulation feature makes it less attractive to investors seeking consistent income, as it carries a higher risk of forfeited payments.

Claim on Company Assets

In liquidation or bankruptcy, claims on a company’s assets follow a specific order. When a company undergoes liquidation, its assets are sold off, and the proceeds are distributed to various claimants. Creditors, including bondholders, are typically paid first from the company’s remaining assets. This includes secured creditors, who have claims backed by specific assets, followed by unsecured creditors.

After all creditors have been satisfied, preferred stockholders have the next claim on any remaining assets. They are entitled to receive their initial investment back, along with any accumulated unpaid dividends if the preferred stock is cumulative, before common stockholders receive anything. This higher position provides preferred shareholders with greater protection for their investment.

Common stockholders are last in line to receive any distribution from the company’s assets during liquidation. Their claim is considered residual, meaning they only receive what is left after all creditors and preferred shareholders have been paid. In many liquidation scenarios, insufficient assets may remain to distribute to common stockholders, resulting in a complete loss of their investment.

Investment Characteristics and Features

Beyond voting rights, dividends, and asset claims, common and preferred stocks exhibit distinct investment characteristics. Common stock generally offers greater potential for capital appreciation, an increase in the share price over time. Investors in common stock aim to profit from the company’s growth, increased profitability, and overall market demand for its shares. However, this potential for higher returns comes with increased volatility, as common stock prices can fluctuate significantly based on market sentiment, economic conditions, and company-specific news. Common stock is often favored by investors with a growth-oriented strategy and a higher tolerance for risk.

Preferred stock, conversely, often behaves more like a bond than a traditional equity, providing a more stable income stream through its fixed dividends. This characteristic makes preferred stock appealing to income-focused investors who prioritize regular payouts over significant capital gains potential. While preferred stock prices are generally less volatile than common stock, they can still be influenced by changes in interest rates; if interest rates rise, the value of existing preferred shares, with their fixed lower dividend rates, may fall.

Preferred stock can also come with unique features that further define its investment profile.

Convertibility

Convertibility allows preferred shareholders the option to convert their preferred shares into a predetermined number of common shares, typically under specific conditions or after a certain period. This feature offers investors the stability of preferred dividends while retaining the potential to participate in the company’s growth if the common stock price appreciates.

Callability

Callability grants the issuing company the right to repurchase, or “call,” the preferred shares from investors at a specified price after a certain date. Companies may exercise this right if interest rates decline, allowing them to refinance at a lower dividend rate, or to gain more control over their capital structure. While callable features introduce some reinvestment risk for investors, they often come with a call premium, an amount paid above the par value, to compensate for the early redemption.