What Is the Difference Between Common and Preferred Stock?

Stocks serve as a fundamental investment vehicle, allowing individuals to own a portion of a company. This ownership stake provides an opportunity to participate in the company’s financial performance. Investors typically acquire stock with the expectation of generating a return on their investment. This article clarifies the distinctions between common stock and preferred stock, two primary types of equity instruments. Understanding these differences is helpful for navigating investment opportunities and aligning choices with individual financial objectives.

Understanding Common Stock

Common stock represents the most prevalent form of equity ownership in a company, granting shareholders a stake in the business and its potential future revenues. A primary characteristic of common stock is the provision of voting rights, allowing shareholders to influence significant company matters. These rights generally include the ability to elect members to the board of directors and vote on major corporate decisions, such as mergers, acquisitions, or other fundamental changes. Each share of common stock usually carries one vote, though companies may issue different classes of stock with varied voting powers.

Dividends for common stock are not guaranteed and can fluctuate significantly based on the company’s financial performance and the discretion of its board of directors. A company’s board must declare a dividend before it is paid, and they may choose to retain earnings for reinvestment into the business rather than distributing them to common shareholders.

Common stock offers substantial potential for capital appreciation, meaning the value of the shares can increase significantly if the company performs well and its market value rises. This growth potential is a primary driver for many common stock investors, as there is generally no upper limit to how much the stock price can increase. However, this potential for higher returns is accompanied by increased risk, as the stock’s value can also decline if the company’s performance falters.

In the event of a company’s liquidation or bankruptcy, common stockholders have the lowest priority claim on the company’s assets. After all creditors, including bondholders, and preferred stockholders have been paid, common shareholders receive any remaining assets. This subordinate position means that in many bankruptcy scenarios, common stockholders may receive minimal or no proceeds from the liquidation.

Understanding Preferred Stock

Preferred stock represents a unique class of shares, often described as a hybrid security because it combines features of both traditional stocks and bonds. While it signifies ownership in a company, similar to common stock, preferred stock typically offers different rights and benefits. A defining characteristic of preferred stock is its fixed dividend payment, which is usually set at a predetermined rate and paid regularly. These dividends are prioritized over common stock dividends, meaning preferred stockholders generally receive their payments before any dividends can be distributed to common shareholders.

Unlike common stock, preferred stock generally does not grant voting rights in company matters. This absence of voting power means preferred stockholders typically have little to no direct influence on corporate governance, such as electing board members or approving major strategic decisions. Their investment focus is often on income generation rather than active participation in the company’s direction.

In the event of a company’s liquidation, preferred stockholders hold a higher priority claim on the company’s assets compared to common stockholders. This means that after bondholders and other creditors are satisfied, preferred shareholders are next in line to receive distributions from any remaining assets before common stockholders. This higher claim provides a degree of protection, making preferred stock generally less risky than common stock in scenarios of financial distress.

Many preferred stocks also feature a “callable” provision, allowing the issuing company to repurchase the shares at a specified price after a certain date. This callable feature provides the company with flexibility, enabling them to redeem the shares if, for instance, interest rates decline and they can issue new preferred stock at a lower dividend rate. While beneficial for the issuer, this can limit the investor’s potential for long-term income from that specific security.

Comparing Stock Types

The fundamental differences between common and preferred stock significantly impact investor rights and potential returns. Common stockholders typically possess voting rights on company matters, whereas preferred stockholders generally do not have such voting privileges. This distinction means common shareholders can influence corporate decisions, while preferred shareholders usually forgo this influence in exchange for other benefits.

Regarding dividend payments, preferred stock typically offers fixed, regular dividends that take precedence over common stock dividends. Common stock dividends, conversely, are variable and not guaranteed, dependent on company performance and board declarations. This prioritization makes preferred stock appealing to income-focused investors, while common stock offers more unpredictable, yet potentially higher, dividend payouts.

Capital appreciation potential also differs between the two stock types. Common stock often provides greater opportunity for significant capital gains if the company’s value increases, as there is no fixed redemption price. Preferred stock, with its fixed dividend and often bond-like characteristics, typically has more limited capital appreciation potential, with its value more closely tied to interest rate movements.

In the event of a company’s liquidation, preferred stockholders have a higher claim on assets than common stockholders. This means preferred shareholders are paid before common shareholders, but after bondholders and other creditors. Common stockholders are last in line for asset distribution, making their investment riskier in scenarios of company failure.