The argument amongst people when it comes to common stock vs. preferred stock doesn’t seem to know any bounds at the moment. There are people who prefer the latter over the former. Also, there are some people who don’t understand what both mean in the first place. The truth is that if you really want to become a successful stock investor, it is important to have sound knowledge about preferred stock and common stock.
This post will be explaining both in clear details. There is no doubting the fact that after checking out the write-up below, you will be in a much better position to make the right decision about which one is better for your investment goals.
Preferred stock vs. common stock
Preferred stockholders have a much higher claim on the assets and ownership of a company as compared to common stock investors. In the event of liquidation, their claims to assets are much higher. Apart from that, they can also enjoy certain rights which holders of common stock will not. For instance, they can get access to much higher dividends.
If you own preferred stock, note that you won’t have voting rights. It is similar to a bondholder in such regards. The major difference is that you will be paid a dividend while a bond holder will be paid interest. It is important to note that holders of such stock are only entitled to fixed dividends. Normally, they are paid before holders of common stock will be considered. During liquidation, preferred stockholders are given more attention as compared to common stockholders. This happens after bondholders must have been taken care of.
Common stockholders also have rights to ownership of a company. Just like holders of preferred stock, they are also entitled to dividends. They enjoy the privilege of voting board of directors. It has been discovered that most of the time, potential investors prefer buying common stock as compared to preferred stock.
When people talk about a company’s “shares”, they imply common stock. This is because it gives them the right to claim some percentage of the company’s ownership. Unlike preferred stock holders, they have voting rights. Therefore, they can take active part in the company’s board of directors election. The voting rights of a holder of common stock may depend on the number of shares owned. For instance, the more common shares you own, that is how your voting rights will increase.
Although these investors are entitled to dividends, they usually have one primary goal in mind. This is buying the shares, waiting until the company begins to expand and sell at much higher price in order to make profits.
Here is something you should know
One aspect where preferred stock seems to differ is that it combines the features of both bonds and common stock. For instance, bondholders receive a fixed interest on the amount they have borrowed from the company. Preferred stock investors also receive a fixed amount of dividend on a regular basis.
The difference between common and prefered stocks
Having known what both preferred stock and common stock means based on the explanation above, there is every reason to believe that you are eager to find out which areas they tend to differ. There is no need to worry though as this section will be discussing their differences in clear details.
Stockholders voting rights
Just as said above, preferred stockholders don’t have any voting right. This means that when it is time to elect directors of the company, they don’t have any way of choosing their preferred individuals. Apart from elections, they don’t also have any voice when the policies of a company are about to be adopted or changed. They are only paid fixed dividends over a given period of time.
Common stockholders, on the other hand, are quite different. This is because they seem to be more active in all of these processes as compared to preferred stock holder, they have voice in how the company is being managed via policies and choice of directors. There are companies which don’t pay out dividends to their common stock holders though.
What determines/influences their value
Apart from preferred shares having a par value, their value is greatly influenced by interest rates. For instance, when there is an increase in interest rate; that is how their value will start experiencing a decline. On the other hand, a fall in interest rates can cause their value to increase. The amount that preferred stock tends to pay out is actually based on such an interest rate.
The valuation of common stock is not based on any increase or decrease of interest rate. Instead, such is largely influenced by supply and demand. Participants in the market also have a huge role to play. For instance, once demand for such shares increases as a result of factors that are favorable, the price is likely to increase.
One of such favorable factors could be the company performing beyond expectations. It can also be the company planning to dominate its industry in the next decade due to an innovation.
Their dividends
This is another aspect or area where preferred stock and common stock seem to be different. Although it was stated earlier that both groups of investors receive dividends, they are not on the same level. For instance, preferred stock tends to attract a fixed rate of dividend. Even if the company doesn’t perform well after announcing its profits, these investors will be paid dividends.
Common stockholders are different in such regards. For instance, they don’t receive fixed but varied dividends. This could be $2 in the first quarter and $0 in the second quarter. Dividends to be paid are highly dependent on the company’s overall performance over a trading period. One of the reasons why people usually go for preferred stock is that it has a much lower rate of volatility as compared to common stock.
You will see that the dividend is fixed and will always be paid unless the company is liquidated. Common stock on the other hand is highly volatile. Their investors are prone to all kinds of dangers especially when the company doesn’t perform well. In other words, they are highly unpredictable.
In a situation where a company fails to pay preferred stock holders due to poor performances, it means it will pay them double in subsequent quarter reports. For instance, preferred stockholders are usually paid $3 after every quarter. However, they were not paid in the second quarter due to poor performances. This means they will be paid $6 in the third quarter. This is an addition of the present dividend and that which wasn’t paid in the second quarter. In other words, they will be paid in arrears before any other.
Order of paying dividends
When earnings are announced in companies, there is usually an order that investors are going to be paid. For instance, no company pays all of its investors at once. This is because some are considered of utmost priority than others. The first amongst all that is paid are bondholders. These are not paid dividends but interest on money they have borrowed from the company.
Once bondholders have been paid, investors of preferred stock will then be considered. Common stockholders are always the last in such order. It doesn’t mean investing in common stock is a bad option though. For example, they have higher return rates as compared to preferred stock investors. This is because as the company is growing, that is how they are likely to earn more as dividends. Remember it was earlier stated that preferred stockholders are paid fixed dividends.
The problem with common stock in this regard is that there is no guarantee whether they will be paid a dividend. This makes it riskier as compared to preferred stockholders. In case you are planning to invest in the common stock of a company, it is recommended to consider this risk to a great extent.
Convertibility
In case you don’t know, both common and preferred stock seem to be very different in this regard. For instance, it is possible for some preferred stock to be converted into common stock. However, common stock cannot be converted into preferred stock. In the case of the former, it only requires the board of directors to vote for the conversion to be possible.
This can either work in favor or against the investor. It all depends on the price at which such common stock is sold in the market. Whatever the case may be, it is quite obvious that when it comes to convertibility, preferred stock tends to be more flexible as compared to common stock.
Final words
Having seen the above, it is obvious that common stock and preferred stock are not the same. They only tend to have few similarities. Therefore, it is crucial to weigh your options very well before deciding to invest in any of them. Always remember that they both have their advantages and disadvantages. Don’t forget to always do your own research and reduce the risk by diversifying your portfolio.
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