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Common Stock vs Preferred Stock – What’s the Difference?

Common Stock vs Preferred Stock

Common Stock vs Preferred StockThere are many differences between common stock vs preferred stock. However, a key difference has to do with voting rights.  Preferred stock usually does not give shareholders voting rights.  Common stock does, usually at one vote per share owned. Many investors know quite a bit about common stock and little about preferred. However, both types of stock represent a piece of ownership in a company.  Also, both are tools investors can use to try to profit from the future successes of the business.

The key advantage with common stock, is that shareholders can participate in the growth of a company.  This growth is realized through the price appreciation of the shares. Common shareholders also receive voting rights on company issues including selection of the board of directors.

Something to keep in mind is preferred shareholders have priority over a company’s income.  This means they are paid dividends before common shareholders. Common stockholders are last in line when it comes to company assets.  They will be paid out after creditors, bondholders, and preferred shareholders.  Preferred stock can be seen as a hybrid product between stocks and bonds.  Preferred stock is classed as equity, but shares some of the characteristics of a bond. For example, like bond owners, shareholders of preferred stock do not have voting rights. However, in the event of a bankruptcy and subsequent liquidation of the business, preferred stockholders are paid before common stockholders, but after bondholders.

Common Stock

Common stock represents shares of ownership in a corporation.  It is the type of stock in which most people invest. When people talk about stocks they are usually referring to common stock. In fact, the great majority of stock is issued is in this form. Common shares represent a claim on profits and confer voting rights. Investors most often get one vote per share-owned to elect board members.  These individuals oversee the major decisions made by management. Stockholders thus have the ability to exercise control over corporate policy and management issues.  Preferred shareholders generally are not given voting rights.

Appreciation – In terms of appreciation in value, common stock tends to outperform bonds and preferred shares. It is also the type of stock that provides the biggest potential for long-term gains. If a company does well, the value of common stock can go up. But keep in mind, if the company does poorly, the stock’s value will also go down. Preferred shares can be converted to a fixed number of common shares, but common shares don’t have this benefit.

Dividends – When it comes to a company’s dividends, the company’s board of directors decides whether or not to pay out a dividend to common stockholders. If a company misses a dividend, the common stockholder gets bumped back for a preferred stockholder.  Paying dividends is a higher priority to preferred shareholders for the company. The claim over a company’s income and earnings is most important during times of insolvency. Common stockholders are last in line for the company’s assets. If a company must liquidate, it must pay all creditors and bondholders first.  Common stockholders will not receive any money until after the preferred shareholders are paid out.

(Source: investopedia.com)

Preferred Stock

A key difference between common stock vs preferred stock is that preferred stock comes with no voting rights. So when it comes time for a company to elect a board of directors or vote on any form of corporate policy, preferred shareholders have no voice in the future of the company. In fact, preferred stock functions similarly to bonds more than stocks.

Dividends  

With preferred shares, investors are usually guaranteed a fixed dividend in perpetuity. The dividend yield of preferred stock is calculated as the dollar amount of a dividend divided by the price of the stock. This is often based on the par value before a preferred stock is offered. It’s commonly calculated as a percentage of the current market price after it begins trading. This is different from common stock which has variable dividends that are declared by the board of directors and never guaranteed. In fact, many companies do not pay out dividends to common stock at all. Like bonds, preferred shares also have a par value which is affected by interest rates. When interest rates rise, the value of the preferred stock declines, and vice versa.

Share Price Appreciation

Callability Feature

Unlike common shares, preferred stocks also have a callability feature.  This gives the issuer the right to redeem the shares from the market after a predetermined time. Investors who buy preferred shares face a real possibility for these shares to eventually be called back.  However, at a redemption rate representing a significant premium over their purchase price. The market for preferred shares often anticipates callbacks and prices may be bid up accordingly.

(Source: ibid)

Common Stock vs Preferred Stock – Why The Difference?

Companies use preferred stocks to raise capital for growth through equity, not debt. The corporation’s ability to suspend the dividends is its biggest advantage over bonds. It just requires a vote of the board. They run no risk of being sued for default if they suspend dividends. However, if the company doesn’t pay the interest on its bonds, it defaults.

Companies also use preferred stocks to transfer corporate ownership to another company. Companies get a tax write-off on the dividend income of preferred stocks. For example, if a company owns 20% or more of another distributing company’s stock, they don’t have to pay taxes on the first 65% of income received from dividends. Individual investors don’t get the same tax advantage. Second, companies can sell preferred stocks quicker than common stocks. It’s because the investors know they will be paid back before the owners of common stocks will.

(Source: thebalance.com)

Summary: Common Stock vs Preferred Stock

Company ownership

Holders of both common stock and preferred stock own a stake in the company.

Voting rights

Even though both common shareholders and preferred shareholders own a part of the company, only the common shareholders have voting rights. Preferred shareholders do not have voting rights. For example, if there were a vote on the new board of directors, common shareholders would have a voice.  Whereas, preferred shareholders would not be able to vote.

Dividends

Although both shareholders can receive dividends, the payment of dividends differs in nature. For common shares, the dividends are variable and are paid out depending on how profitable the company is. As an example, Company A can pay out $2 in dividends in Quarter 1, but if they lose profitability in Quarter 2, they may choose to pay $0.

In contrast, preferred shareholders receive fixed dividends.  So, Company A would need to distribute a constant dividend of $2 at fixed intervals. The dividends for preferred shares are also cumulative.  This means if they are missed one period, they will need to be paid back in the next.  For example, if Company A misses the $2 dividend for preferred shares in Quarter 2, they will need to pay $4 ($2 x 2) in Quarter 3.

Claim to earnings

When a company reports earnings, there is an order where investors are paid out. Usually, bondholders are paid out first, and common shareholders are paid out last. Because preferred shares are a combination of both bonds and common shares, preferred shareholders are paid out after the bond shareholders but before the common stockholders. In the event that a company goes bankrupt, the preferred shareholders need to be paid first before common stockholders get anything.

Conversion

Preferred shares can also be converted to a fixed number of common shares.  But, common shares cannot be converted to preferred shares.

Returns

Ultimately, both common and preferred shares are paid out of a company’s earnings. The returns of a common share are most commonly based on the increase or decrease of the share price.  Sometimes, including an optional dividend paid out. In contrast, the returns on a preferred share are mainly based on its mandatory dividends.

(Source: corporatefinanceinstitute.com)

Common Stock vs Preferred Stock vs. Bonds

Preferred stocks can make an attractive investment.  Especially, for those seeking steady income with a higher payout than they’d receive from common stock dividends or bonds. But they forgo the uncapped appreciation upside potential of common stocks and the safety of bonds.

A company usually issues preferred stock for many of the same reasons that it issues a bond.  Investors like preferred stocks for similar reasons. For a company, preferred stock and bonds are convenient ways to raise money without issuing more costly common stock. Investors like the preferred stock because this type of stock often pays a higher yield than the company’s bonds. So if preferred stocks pay a higher dividend yield, why wouldn’t investors always buy them instead of bonds? The short answer is that the preferred stock is riskier than bonds. Below are the differences in each asset class in order of risk.

Bonds

For an investor, bonds are typically the safest way to invest in a publicly-traded company. Legally, interest payments on bonds must be paid before any dividends on preferred or common stock. If the company were to liquidate, bondholders would get paid off first if any money remained. For safety, investors are willing to accept a lower interest payment.  This means bonds are a low-risk, low-reward proposition.

Preferred Stock

Next in line from a safety perspactive is preferred stock. In exchange for a higher payout, shareholders are willing to take a spot farther back in the line.  Payouts for preferred stock are behind bonds but ahead of common stock. Their preferred status over common stock is the origin of the name “preferred stock.” Once bondholders receive their payouts, preferred holders may receive theirs. As noted above, sometimes a company can skip its dividend payouts, increasing risk. So preferred stocks get a bit more of a payout for a bit more risk.  But, their potential reward is usually capped at the dividend payout.

Common Stock

At the end of the payout line are common stockholders.  They will receive a payout only if the company is paying a dividend and everyone else in front of them has received their full payout. In the event of a company’s liquidation in bankruptcy, these stockholders get what’s leftover after bondholders and preferred stockholders have been made whole. But unlike with bonds and preferreds, if the company is a success, there’s no upside cap on a common stockholder’s profits. The sky really is the limit when it comes to growth and capital appreciation.

(Source: nerdwallet.com)

Up Next: Day Trading For Beginners – What Is A Day Trader

Day trading can be summarized simply as buying security.  Then, quickly selling or closing out the position within a single trading day.  Ideally, a day trader wants to “cash-out” by the end of each day with no open positions to avoid the risk of losses by holding security overnight.  Day trading is not for everyone and carries significant risks. It requires an in-depth understanding of how the markets work and various strategies for profiting in the short term.  Short term profits require a very different approach compared to traditional long term, buy and hold investment strategies.

 

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