What Is the Difference Between Common and Preferred Stocks?

Common and preferred stocks both represent forms of ownership in a company, granting investors a stake in its future performance. While both are equity instruments, they possess distinct characteristics that appeal to different investor objectives. This article outlines the primary distinctions between common and preferred stock, covering investor rights, financial characteristics, and market behaviors.

Key Distinctions in Investor Rights

A primary difference between common and preferred stock lies in the voting rights granted to shareholders. Common stockholders typically possess voting rights, allowing them to participate in important corporate decisions, such as electing the board of directors or approving mergers. This provides common shareholders with a voice in the company’s governance.

Preferred stockholders, in contrast, generally do not have voting rights, or their voting rights are limited, often only activated under specific circumstances like dividend arrearages. This means preferred shareholders have little direct influence over the company’s management. Another significant distinction emerges during a company’s liquidation or bankruptcy. Preferred stockholders hold a higher claim on the company’s assets and earnings than common stockholders.

If a company ceases operations and its assets are liquidated, preferred shareholders are paid out before common shareholders, after all creditors have been satisfied. This preferential treatment means preferred stockholders have a greater assurance of recovering their initial investment. Common stockholders receive any remaining assets only after preferred shareholders have been fully compensated.

Financial Characteristics and Payouts

The manner in which common and preferred stocks generate returns for investors, particularly through dividends, presents another significant divergence. Preferred stock typically offers fixed dividend payments, meaning the dividend amount is usually a set percentage of the par value and does not fluctuate with the company’s profitability. These dividends are often paid regularly, providing a predictable income stream for investors. Some preferred stocks are cumulative, which means if the company misses a dividend payment, it must pay all accumulated missed preferred dividends before any dividends can be paid to common stockholders.

Conversely, dividends for common stock are variable and are not guaranteed. These payments can fluctuate based on the company’s earnings, financial health, and strategic reinvestment needs. Companies may choose to increase, decrease, or even suspend common stock dividends depending on their profitability and cash flow. This variability means common stockholders face greater uncertainty regarding dividend income compared to preferred stockholders.

Additional Features and Market Behavior

Beyond rights and payouts, common and preferred stocks differ in their potential for capital appreciation and specific contractual features. Common stock generally offers a higher potential for capital appreciation, linked to the company’s growth, profitability, and overall market sentiment. In contrast, preferred stock typically has less capital appreciation potential because its price tends to be more stable, often trading closer to its par value.

Preferred stocks can also include features such as convertibility and callability, which are rarely found in common stock. Convertibility allows preferred shares to be exchanged for a predetermined number of common shares, offering investors the opportunity to participate in the common stock’s growth potential. Callability gives the issuing company the right to repurchase the preferred shares at a specified price after a certain date, which can limit the investor’s upside if interest rates fall or the stock performs well. The market behavior of these two stock types also varies; common stock prices are generally more volatile and sensitive to company news, economic data, and broader market sentiment. Preferred stock prices tend to behave more like bonds, showing greater sensitivity to changes in interest rates.

Similarities as Equity Investments

Despite their distinctions, common and preferred stocks share fundamental characteristics as equity investments. Both represent a form of ownership interest in a company, meaning investors in either type of stock are part-owners of the issuing corporation. This ownership grants them a claim on the company’s earnings and assets, albeit with different priorities.

Both common and preferred stocks are typically traded on major stock exchanges, allowing investors to buy and sell shares in the secondary market. This provides liquidity for investors who wish to convert their holdings into cash. Ultimately, both types of instruments are classified as equity on a company’s balance sheet, distinguishing them from debt instruments like corporate bonds.