What Is the Difference Between Preferred and Common Stock?

Ownership shares represent a stake in a company, signifying equity and granting certain rights to the holder. Companies issue these shares to raise capital for their operations, growth, or other financial needs. Investing in a company’s shares means acquiring a portion of its equity, making you a part-owner. Understanding this concept is fundamental to distinguishing between different types of shares.

Understanding Common Stock

Common stock represents ownership in a corporation and typically provides shareholders with voting rights. These rights allow common stockholders to influence major corporate decisions, such as electing the board of directors or approving mergers. Each share generally grants one vote, giving investors with more shares greater voting power. Shareholders can exercise these rights at annual meetings or through proxy voting.

Common stockholders hold a residual claim on the company’s assets and earnings. In a company’s liquidation, they are paid only after all creditors and preferred stockholders. The value common stockholders receive can range from a portion of remaining assets to nothing, depending on the company’s financial state. This highlights the higher risk associated with common stock.

Dividends for common stock are not guaranteed and fluctuate based on company performance and board decisions. The board determines if and how much earnings will be distributed as dividends. These dividends can be paid in cash or additional shares. The potential for capital appreciation, where the stock’s market value increases with company growth, is a primary reason investors hold common stock.

Dividends received by common stockholders are subject to federal income tax. They are categorized as either “qualified” or “ordinary” for tax purposes. Qualified dividends, which typically come from U.S. corporations and meet specific holding period requirements, are taxed at lower long-term capital gains rates. Ordinary dividends are taxed at an investor’s regular income tax rate.

Understanding Preferred Stock

Preferred stock offers a different set of features compared to common stock, primarily characterized by fixed dividend payments. These dividends are typically calculated as a percentage of the stock’s par value and are paid at regular intervals. Preferred dividends must be paid out before any dividends can be distributed to common stockholders.

Preferred stock generally does not carry voting rights in corporate matters. This absence of voting power means preferred stockholders typically have less direct influence over a company’s management and strategic decisions.

In a company’s liquidation, preferred stockholders have a higher claim on assets than common stockholders. They are paid after all creditors but before common stockholders receive any distribution. This priority provides a layer of security for preferred shareholders, increasing their likelihood of recovering their initial investment.

Preferred stock typically offers less potential for capital appreciation compared to common stock. Its value is more closely tied to its fixed dividend payments, functioning somewhat like a bond. Some preferred shares may include features like convertibility or cumulative provisions. Cumulative preferred stock means any missed dividend payments accumulate and must be paid before common stockholders receive dividends. Non-cumulative preferred stock does not have this provision; missed dividends are simply forfeited.

Key Differentiating Factors

The distinction between common and preferred stock lies across several key areas, beginning with voting rights. Common stockholders typically possess voting rights, allowing them to participate in major corporate decisions. Preferred stockholders, in contrast, generally do not have voting rights, limiting their direct influence over company governance.

Dividend payments also differ significantly. Preferred stock offers fixed, regular dividend payments that must be paid before any common stock dividends. Common stock dividends are variable, not guaranteed, and depend on company performance and board discretion.

Another differentiating factor is the claim on assets in liquidation. Preferred stockholders have a higher priority claim on assets than common stockholders. After creditors are paid, preferred shareholders receive their portion before common shareholders. Common stockholders are last in line and may receive nothing.

The potential for capital appreciation also varies. Common stock typically offers greater potential for capital appreciation, as its market value can increase significantly with company growth. Preferred stock generally has less potential for substantial price increases, with its value more influenced by interest rate movements and its fixed dividend stream.

Investor Perspectives

Investors choose between common and preferred stock based on their financial goals and risk tolerance. For those seeking capital appreciation and a direct say in corporate governance, common stock is often preferred. These investors are comfortable with the higher risk associated with variable returns and the residual claim on assets, betting on the company’s growth potential. The possibility of significant gains aligns with a growth-oriented investment strategy.

Conversely, preferred stock appeals to income-oriented investors who prioritize stable, predictable returns and capital preservation. Fixed dividend payments provide a reliable income stream, attractive for retirees or those seeking consistent cash flow. The higher claim on assets in liquidation offers security not found with common stock, making preferred shares suitable for investors with lower risk tolerance. The decision depends on whether an investor values potential growth and voting power over income stability and liquidation priority.