Preferred Vs Common Stock: An Overview

If you’re in the stock market for a while, you must be aware of the term preferred stock, common stock, bond. By comparing Preferred Vs Common Stock, I am going to reveal most of the information you would need to read. When a business runs, you can predict that there is always been a requirement for capital investment.

Be it a start-up, a small business or an established one, every setup needs money. A small business can finance its business by its own capital. But a big business house or a private company often funds its capital requirement through project finance or issuing shares to the public.

When a business wants to raise money, it does so by offering its shares to the public via stock exchanges. This public offering is known as IPO (Initial Public Offering). A company can offer common stock or preferred stock. Common stock and preferred stock are both worthwhile investments. Now, depending upon your needs, one category of stock may be a better choice for you than the other one. But you’ll definitely want to choose the one that has the best chance of fulfilling your needs.

You can trade common stocks and preferred stocks in the open market. Both offer the stockholders a partial ownership in the company. Despite those similarities, both common stock and preferred have some significant differences. But before buying them, you need to understand the strengths and weaknesses of both types of stocks.

What is Common Stock?

And when we talk about stock, it’s usually common stock. By investing in common stocks, you as a shareholder can earn dividend income and can also sell out the stocks in your holding at a higher price. You will have the voting rights on corporate issues or take part in the decision-making process of the company.

The major drawbacks (which I will discuss in detail) of the common stocks are arising when the company goes bankrupt. In that case, you are the last person to get your capital back after repaying the creditors, bondholders, and holders of preferred stock.

Common stocks that had issued by companies are usually freely floated in the stock market. In fact, the great majority of stocks are come in this form. As an investor of common stocks, you’re entitled to get the profits of the company via dividend route and capital appreciation.

On top of all this, it is the company’s board of directors who will decide whether you will get dividends or not. The members are the ones who oversee the major decisions making of the management. Stockholders thus have the ability to exercise their rights over corporate policy and management issues.

In this case, you can also get profits through capital gains. The return, alongside the principal value of common stocks, varies with changes in market conditions. You can get more or less value of share price if you decide to sell in the open market. On top of it, there is no guarantee that you will get dividend payments. Hence before investing in common stock, you should consider your risk tolerance.

In the event of bankruptcy, common stockholders get shares of profit earned by the company after paying first to preferred, bondholders, and creditors. As a matter of fact, the common stock-holders literally get nothing after liquidation. Common stockholders, however, can earn money through capital appreciation. Common shares have the ability to perform better than preferred shares or bonds in the long run.

Common Stocks Definition:

Common stocks are the ones that a publicly-traded company usually issues to raise funds for meeting its business needs at a marketable price. The market price of an issued stock may be unstable in the intermittent period, but on a long haul, it builds its net-worth as the earnings get adding. The price fluctuation of common stock is very common due to speculation in the market.  

Common Stock is made up of equity capital of a company and investors are the primary shareholders. Equity holders are the owner of the company. As an equity holder or stockholder, you are entitled to bear the profit and loss of a company after all the dividends and debts are paid off.

Common stocks are part of the equities of a publicly-traded company that is built-up of shareholder’s funds. By taking part in the fundraising, the stockholders are accepting both risk and rewards of ownership. But their liability is limited to the capital contributed by them.

Preferred Stock Definition:

Preferred stock or simply preferred is a type of stock that has features not possessed by common stock. It possesses the combination of the characteristics of both equity and debt instrument. You’ll find some special features in a preferred. As a preferred stock-holder, you will get preference in the company’s dividends, and assets of the company in case of liquidation. Also, you’re entitled to convert preferred into common stock, and get benefited from features like callability or ability to redeem a preferred before it matures. But you’ll miss the opportunity of voting right, and higher dividend yields. 

In the section of the company’s articles of association or articles of incorporation, you can find terms of possession of preferred. Preferred stockholders are also the owner of a company. Just like a bond, major credit rating agencies usually rate preferred stocks. Here the rating is usually lower than bonds. The reason for this is that the dividend of preferred never carries the same guarantees as interest payments of bonds.

What Is Preferred Stock?

Preferred stock also enjoys the ownership of the company, but it slightly differs from a common stock. It pays a preset dividend, whereas the dividends that pay to common shareholders are determined according to the company’s profitability. Dividends that you usually get from a preferred stock are greater than the common stock or bonds of the company.

You, however, won’t get the voting rights on the company’s matters. Preferred is usually less volatile than common stock. Chances are you typically will get less profit. But you have a greater claim to the company’s assets. Like a bond, preferred stock is callable in nature, which means the company can buy back shares from you at any time at a favorable price.

And at the event of liquidation of the company’s assets, you as the preferred stockholders have the priority to redeem your shares before common stockholders do. This is why preferred gives you a better chance of getting your money back. 

Here you also will get the dividends before common stockholders receive theirs. Dividends of preferred tend to be higher than common stockholders. And you usually get fixed and regular dividend payments for a specified period of time. But that is very unlikely for common stockholders where they get variable dividend payments. But keep this in your mind that the fixed dividends that you’ll get depend on the company’s ability to pay you the same.

Although unlike preferred stock, by holding the common stock you can have the potential to get higher yields over time through capital gain. Here one thing you need to remember that if you want to get a higher rate of return, you have to accept the higher degree of risk.

Like common stocks, preferred stocks also gives you the shares of ownership. Both are traded through brokerage firms. In fact, preferred has possessed some qualities of common stock and some of a bond. The price of both stocks does fluctuate with the earnings of the company.

Different Types of Preferred

You’ll find different types of Preferred Stocks available in the market as listed below:

Cumulative Preferred stocks: In the worst situation, the company may suspend dividends payment with a condition that when bad times get better the company must pay the entire unpaid dividend. And it must do this before dividend payments to common stockholders. ​​

Non-cumulative preferred stock: Unlike Cumulative preferred, dividends, if unpaid for this type of preferred stock will not accumulate. This is very common in bank preferred stock.

Convertible Preferred Stocks: With this type of stock, you have the option to convert them into common stock for a pre-determined number at any time in the future. There are three things you need to pay attention to. You can convert preferred into common stocks under three situations.     

#1: When the Board of Directors of the company vote to exercise for the conversion of preferred into common stocks.

#2: Stocks are set to automatically convert into common stocks on a pre-set date

#3: If you’re decided to convert preferred into common stocks, you are only allowed to exercise this option if the market price of the common stock is greater than the net present value of your preferred.

Redeemable Preferred: This gives the company the right to redeem the preferred at any time after a certain date. It usually pays a higher dividend.  This is because of the fact that the company could demand redemption if interest rates drop.

Participating Preferred Stock: In this type of stocks, the company pays you a specific dividend before it pays out to common stockholders at liquidation. Usually, the stock investors of private and venture capital firms participate in it.

Adjustable-Rate Preferred: A company usually pays out a dividend at modified rate in the benchmark rate. A common benchmark is a rate that is tied to the Treasury bills.   

Prior Preferred Stock: Among different priorities of issuing preferred, many companies may have one issue that is usually designated highest-priority. If the company has enough money to meet the dividend schedule, it pays dividends on the prior preferred, which prior preferred less credit risk than other preferred stocks.

Perpetual Preferred Stock: Here, there is no fixed date to return the invested capital to the shareholder. Most of the preferred issued without a redemption date.

Why A Company Issues Preferred Stocks?

A Company usually issues preferred stocks to raise capital for its future business growth. The company can suspend anytime to pay you out dividends. Voting in the board meeting of the company can only decide this. The company can’t be sued for defaulting to pay dividends. It defaults if the company fails to pay the interest on its bonds.  

The corporate ownership of preferred can be transferred to another company. Companies are able to get a tax deduction on the dividend income. As an individual investor, you can’t get the same tax advantage. And another advantage of owning preferred is that you can sell it quicker than common stocks. 

Preferred are frequently issued as a last resort. A company uses it after issuing common stocks and bonds. Preferred is usually more costly than bonds. You get dividends from the company’s after-tax profits.

Preferred Vs Common Stock Vs Bond

There are a lot of differences between preferred and common stock. The main difference is that the preferred stock-holders usually don’t have the privilege to enjoy voting rights in company matters. On the other hand, common stock-holders do enjoy voting rights for the shares they owned.

In both cases, you will get partial ownership in the company, and earn profits from the investment made as long as the company’s success story remains intact. Because of the inability to access voting rights, the preferred stock-holders don’t have a voice when it’s come to vote on any corporate policy. Preferred stock works just like bonds since it usually gives you a   guarantee of fixed dividend yield.

The dividend yield of a stock is defined as the dollar value of dividends divided by the market price of a stock. The dividend is primarily aimed at seeking regular income. The higher dividend yield means the more stable a company. This is not the case with common stock where a dividend is variable and never guaranteed.

Many a time, some companies do not pay out dividends to common stock-holders at all. And similar to a bond, the par value of preferred stocks is influenced by the fluctuation of interest rates.

The value of common stocks is regulated by the demand and supply of the market participants. In an event of liquidation, preferred stock-holders have the priority to claim to a company’s assets and earnings. This may not arise as long as the company has excess cash and decides to distribute its profits or dividends to its investors.

A company may miss a dividend payment to the common stock-holders, but can’t do so to preferred stock-holders. It must pay any arrears to preferred shareholders before paying out the same to common shareholders.

Preferred shares also have a special callability feature which grants them the right to redeem the shares after a preset time. If you’re holding jumbos of preferred stocks of a fine company and after a predefined time frame it’s offering you a buy-back price of redemption that is well above the purchase price. Isn’t it a real good opportunity? 

Common stock usually outperforms bonds and preferred stocks. It provides great potential for long-term gains. If a company performs well, the value of a common stock surge. But when the company performs poorly, the stock’s value will plunge.

Preferred can be converted to common stocks. But common stocks don’t have this privilege. When it comes to dividends, the company’s management will decide whether or not to pay a dividend to common stockholders. And when a company pays a dividend, it is the common stockholder who gets dividends after paying out that to a preferred stockholder.  

In the event of insolvency, the common stockholders are last in line to claim over a company’s earnings and assets. What does this mean to you? It means that the company must liquidate and pay all creditors and bondholders first. Common stockholders are the last to get any money back until the preferred are paid out.

Preferred stocks pay you a dividend like common stock. The only difference is that preferred stocks pay you dividends at regular intervals at a preset agreed-upon arrangement. This is similar to that of a bond. Common stocks may pay dividends based on how a company is performed.

Like bonds, for preferred stocks, you’ll get your initial investments back if you hold them until maturity. Here is the most concerning fact is that the value of a common stock can fall to zero. If that happens to you, you will end up penniless. The issuer of preferred stocks can dissolve them before maturity.  

corporate bond is a bond issued by a corporation to raise funds for smooth operations or expanding the business of the corporation. This applies to longer-term debt instruments with a minimum of a one-year maturity.

Who Buys Preferred Stock and Why?

You can buy preferred stocks of any publicly-traded company in similar way you buy common stocks. Your broker can help you in buying them. But this may not be suitable for retail investors. Institutional investors mostly buy preferred when a company goes for public listing. This is because of the fact that institutional investors get an incentive to buy preferred in large chunks.

But you as an individual retail investor can’t get this type of incentive. And not getting this generous incentive, preferred stocks become less attractive to the retail investors. However, you can consider preferred as a diversified investment portfolio. It may not be a true alternative to common stock. But bonds related to equity can be an alternative.

Bonds and preferred stocks have guaranteed periodic payments. The only significant difference between them is that the bond pays interest on the debt. While the dividend of a preferred share is given on par value at the rate stated during issuance.

Preferred are especially suited to the portfolios of wealthy investors. This is because of the relative stability of the investment, rather than the greater average returns on investment of common stock.

Can you convert common stock to preferred stock?

Once conversion completed, you can’t convert the common stock back to preferred ones. Oftentimes companies reserve the right to buy back preferred stocks at a predefined price. These shares are callable in nature.

Can Preferred Stock Dilute Common Stock?

As a stock investor, you usually provide capital to the company to grow in exchange for an ownership stake in it. These processes substantially add-up more value in its shares and making them worth buying. Over time, when more investors become shareholders, the company may continue to issue new stocks, raising more capital.  This ultimately increases the total number of shares for smaller ownership stakes in the business.

When a company issues stock in this fashion, it dilutes many investors’ ownership stakes. By producing more shares, previous investors now own a smaller percentage in the company.

Like common stock, preferred does not participate in the growth story of a company. The dividends of preferred stock remain fixed even though the earnings of the company grow.

What Are the Advantages of Preferred Stock?

  1. No Obligation for Paying Dividends: A company is not compelled to pay the dividend on preferred when its profits in a particular year are insufficient.
  2. Voting Right: A preferred share does not carry voting rights. Hence, a company can raise capital without dilution of control.
  3. Trading on Equity: The dividend rate of preferred stocks is fixed. So, if the earnings are increased, the company can give the benefits of trading on equity to the equity stockholders.
  4. No Mortgage on Assets: Preferred shares of a company do not produce any mortgage or charge on its assets. So, the company can keep its fixed assets free for raising fund in future

What Are the Disadvantages of Preferred Stock?

A major benefit the preferred stockholders get is that they receive dividend payments before common stock shareholders. However, the major drawback is that preferred have no voting rights as common shareholders typically do.

Can You Convert Preferred Stock to Common Stock?

You can convert a convertible preferred at any time after the conversion date.  But sometimes the issuer can ask for forced conversion. Thus, converting preferred into common stock dilutes the common shareholders stake. That’s why companies sometimes offer a buy-back option if preferred.

Is Preferred Stock Costing More Than Common Stock?

Because the preferred has higher and regular dividends, it is less volatile and less risky than common stock. This phenomenon attracts investors towards preferred stock because they are looking for a steady stream of dividends and enjoy appreciation in value.

Does Preferred Stock a Good Investment?

By analysing preferred vs common stock, you will find that dividend income from preferred stock can be an excellent and valid source of income. In many instances, they preferred to offer a much higher yield than corporate bonds.

Can a Private Company Issue Preferred Stock?

A private company never offered its common shares to the public. Venture capital fund and private equity investors are able to inject money into a nonpublic company by buying private preferred stock. Unlike a public company, private preferred shares may come with special voting rights.

Is Preferred Stocks Risk-free?

A major risk of owning preferred is that they are dependable on interest rates. This is because of the fact that preferred stocks often pay dividends at average fixed rates. The share price falls as prevailing interest rates increase. Preferred stocks are subject to present liquidation risks.

Can Preferred Stock Lose Value?

Yes. This is because preferred pay dividends at a fixed rate. Preferred can lose value if interest rates rise. According to investment firm Nuveen, preferred stock prices on an average would fall by about 4.5% if rates rise by one percentage point.

Why Warren Buffett Buy Convertible Preferred Instead of Bonds?

Legendary investor Warren Buffett always prefers to buy preferred stock in companies. During the financial crisis, his $5 billion investment in Goldman Sachs Group Inc (GS) had saved it from bankruptcy.  This was also true for his recent investments in Bank of America Corp or Kraft Heinz Co.

Preferred Vs Common Stock: Pros and Cons

Major pros and cons of Preferred Vs Common Stock: Preferred stock usually pays a higher dividend than common stock. This rule sometimes can change in certain circumstances. If you closely compare preferred vs common stock, you’ll see that the dividends payment cycle of the preferred stock is pre-set. But, when the company decides to issue a larger dividend than it originally planned, the dividends on common stock can increase. Sometimes it can rise above dividends of preferred stock.

Preferred are similar to bonds. They render yields at pre-defined rates and at regular intervals. When the interest rate goes up, preferred lose value and vice versa. But returns of preferred are higher as compared to bonds.  This is why the risk connected with preferred is much higher.

You will have two advantages owing to the preferred stock. The first is its capital structure which is able to deliver the benefit of debt and common stock. In simple terms, the debt holders and preferred stockholders are paid off before common stockholders when the company liquidates.

And the second advantage is the cumulative dividend. It is simply the accumulation of dividends when the company skips dividend payment. But there is no guarantee of dividends paid.  Preferred stockholders, however usually receive missed payments, if the company misses a dividend payment as promised.

Preferred stock is just like a combination of a bond and common stock. Though preferred stock-holders get the benefits of both types of investments, they also have some drawbacks. Preferred are more volatile than a bond. And sometimes they are as volatile as common stock.

And just like bonds, the shares of preferred stock are sometimes callable. The term callable is simply meant that the company has the right to buy back shares at a pre-set price any time it chooses.

Unless you own a significant percentage of common stocks, you can’t take advantage of your voting rights fully. While the dividends are usually lower, the price of a common stock tends to rise faster than the preferred stock when the company flourish and fall faster when the company runs into trouble.

Preferred Vs Common Stock: Which is Better?

If you refer to live example of preferred vs common stock or common vs preferred stocks, you will find that most of the investors prefer common stock and find it a better deal. Many a time it’s riskier than preferred stock. And eventually, you will be able to get a higher return for your common stocks. But, if you want to get higher returns from stock investment and at the same time want to minimize or exposure to company-specific risk, the preferred stock might be a better choice for you.

 Preferred stock may be the best when you’re looking for a solid source of income you can depend on. This is because the dividends paid on such preferred stock are fixed. Whichever classes of stock you choose make sure you are comfortable holding them over the long haul.

When You Should Buy Preferred Stocks

When you need a steady stream of income, you should go for preferred stocks. You may choose it when interest rates are low. This is because the dividend income stream of preferred stock is higher than bonds.

Similarly, you should think about selling preferred when interest rates rise. This is because of the fact that higher interest rates make preferred to lose value. Preferred could lose value when stock prices rise. A company could buy the preferred stocks back from you before the prices get to any higher. This is also true with bonds as well.

FINAL TAKEAWAYS

  • Preferred Vs Common stock: The major difference between preferred and common stock is that common stock gives voting rights to its stock-holders while preferred stock gives no voting rights.
  • Common stockholders are the last getter of the company’s assets after paying out its creditors, bondholders, and preferred shareholders.
  • Preferred shareholders have priority over a company’s profits and get dividends before common shareholders.

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