Jun 13, 2023
Preferred vs. Common Stock
When you invest in a company by purchasing shares of stock on the stock market, you may have the option to choose between preferred stock vs. common stock. While both types of stock grant investors an ownership stake in the company and provide an opportunity for profit, there are some key differences regarding shareholder rights, risk, and potential returns.
- Common stocks are, as the name implies, the ones most commonly purchased by investors and most frequently offered by companies. These stocks grant common shareholders ownership rights in the company, and their typical value comes from growth in share price. They’re seen as higher risk than preferred stocks.
- Preferred stocks combine characteristics of common stocks and bonds. They pay shareholders a specified dividend and give them priority over common stockholders for receiving dividends, but typically don’t come with voting rights in the company.
By understanding how these two types of stock differ, you’ll be more equipped to decide which makes the most sense for your risk tolerance and investing goals.
In this article, we’ll cover:
What is common stock?
Common stock is a type of security that represents ownership in a company. Common stockholders typically get voting rights in company decisions, usually one vote per share. Some common stocks pay dividends, but the primary way in which investors can earn a return on common stock is through the growth in share price over time.
Common stocks can appeal to investors because they tend to have higher long-term growth potential than preferred stock or bonds and are the most frequently available type of stock. However, this growth potential comes with risk. Common stockholders have the lowest priority for receiving dividends, as well as any payouts if a company liquidates, so the chances of losing your initial investment or not receiving dividends are higher for common than preferred stock.
Types of common stock
Broadly, common stock falls into two categories: voting and non-voting. These are differentiated by the voting rights you get with ownership and typically have a relatively small price differential.
- Voting common stock: Investors who hold voting common stock can vote in shareholder meetings, including the option to vote by proxy. This is the most typical type of common stock.
- Non-voting common stock: Non-voting common stock is a stock in which the shareholder does not have voting rights. These stocks are usually offered when a company wants to raise new capital from investors without offering control over business decisions.
Pros and cons of owning common stock
Investors generally buy common stock in the hopes of earning a return when the price appreciates or through dividend payments if the company offers them. This comes with higher volatility, higher risks, and higher potential returns than preferred stocks or bonds.
|Performance: In the long term, common stocks tend to outperform preferred shares and bonds||Risk: Common stockholders are last in line to receive payouts if a company liquidates|
|Voting rights: Common stockholders have the opportunity to participate in business decisions||Volatility: Value is determined by the open market, and share prices can be volatile|
|Liquidity: Shares are highly liquid and can be bought and sold at any time||Dividends: Companies are not required to pay dividends on common stock, and when they do, common stockholders are the lowest priority for payout|
What is preferred stock?
Preferred stock is a type of equity that shares characteristics with both common stocks and bonds. Preferred stockholders are given preference over common stockholders when dividends are paid and assets are distributed. While they have rights to a company’s profits, they generally have no or limited voting rights in corporate governance.
The most significant appeal of preferred stock to investors is often the higher priority for dividends, making them a good source of predictable income. Dividend payments are prioritized over those for common stockholders, generally yield more, and are generally paid monthly or quarterly.
That said, preferred stock tends to have a lower potential for long-term growth than common stock. Preferred stock is initially priced based on par value, which is the value of the share set by the corporation’s charter, and is not typically related to the value of the company’s common stock being traded on the market. The price of preferred stock is usually tied to interest rates, so it generally changes slowly, making it less volatile but also limiting how much it can increase.
Types of preferred stock
Not all preferred stocks are the same. The different types come with their own advantages and disadvantages that may suit different types of investors and investment goals.
It’s also worth noting that not all companies offer all types of preferred stocks. Many companies do not offer preferred stock at all, so your investment options are more limited than when investing in common stock.
- Cumulative preferred stock: This type of preferred stock requires that any dividends missed in the past, like when a company has a negative stockholder’s equity and can’t afford to pay debts for one or more payment periods, are paid out to the cumulative preferred shareholders first. These shareholders are entitled to missed dividend payments before other preferred stockholders or common stockholders receive any payments.
- Non-cumulative preferred stock: Non-cumulative preferred stockholders are the contrast of cumulative preferred stockholders. These investors have no rights to unpaid dividends, which means that if a company misses dividends, these investors will not receive a make-up payment later.
- Convertible preferred stock: Convertible preferred stocks allow a shareholder to trade their preferred stock for common stock. In most cases, this exchange can happen whenever an investor chooses, but once shares are converted to common stock, they cannot be converted back to preferred stock.
- Participating preferred stock: Participatory shares guarantee additional dividends should an issuing company meet predetermined financial goals. Investors who hold participating preferred stock are entitled to the same dividends as other preferred stockholders, plus additional profit opportunities.
- Callable preferred stock: Callable shares are preferred shares that can be bought back by the issuing company at a fixed price in the future. This has the effect of putting a cap on the value of the stock, limiting a company’s maximum liability to preferred shareholders.
- Adjustable-rate preferred stock: Adjustable-rate preferred stock (ARPS) is a type of preferred stock where dividends issued will vary based on a benchmark rate, which is often the T-bill rate. Modifications to the dividend are based on a predetermined formula and usually take place quarterly.
- Perpetual preferred stock: Investors with perpetual preferred stock are entitled to a fixed dividend for as long as the company remains in business. These stocks do not have a maturity, but they can be bought back by the issuer.
Pros and cons of owning preferred stock
Preferred stocks are a unique hybrid between common stocks and bonds, and they come with distinct advantages and disadvantages. Investors often choose preferred stocks because they provide predictable passive income through dividend payments and prioritization over common stock. Some investors may also have a preference for the stability of knowing their shares will typically remain worth the par value even if the share price of common stock drops below it. But that lower volatility also means shares are less likely to gain significant value.
|Stable price: Preferred stock usually has a more stable price than common stock, which can be advantageous during times of economic uncertainty||Lower capital gains potential: The value of preferred stocks is less likely to go up compared to common stocks|
|Higher dividends: Preferred stockholders receive dividends before common stockholders, and they are typically higher||Voting rights: Preferred shareholders generally don’t get voting rights, so they don’t have a say in a company’s business decisions|
|Security: If a company goes bankrupt and must liquidate its assets, preferred shareholders are paid before common shareholders||Risk: While preferred stockholders are paid dividends and assets before common stockholders, in the case of liquidation, they are still paid after bondholders|
Preferred vs. common stock: which is right for you?
Both preferred stockholders and common stockholders gain ownership in a company by purchasing shares, and both types of stock are tools investors can use to try to profit from a company’s growth and success. The most significant differences lie in voting rights, dividends, payment priority, and growth potential.
Preferred stock is less volatile than common stock but tends to provide lower long-term returns. Common stock, on the other hand, provides more significant potential for long-term gains but is also exposed to higher risk.
|Preferred stocks||Common stocks|
|Definition||A type of equity that entitles the investor to a fixed dividend, which takes priority over common stock dividends||An investment that entitles the investor to voting rights in a company and variable dividends|
|Voting rights||No||Yes, in most cases|
|Dividends||Yes||Possible; depends on the individual company|
|Payment priority||Paid before common stockholders||Paid after preferred stockholders|
Deciding between the two stock types may come down to your risk tolerance, investment time frame, and investment goals. Factors to consider when choosing preferred stock vs. common stock:
- Voting rights: Common stockholders usually have voting rights, and preferred stockholders typically do not. If having a say in a company’s business decisions matters to you, common stocks may fit your needs.
- Dividends: Preferred stockholders are generally paid a fixed dividend, prioritized over common stockholders’ dividends. Because common stock doesn’t always pay dividends and is the lowest priority for payout, preferred stock may make sense if you’re looking for a predictable, steady income stream. Consider common stocks if you’re willing to take on more risk for potentially higher returns and are looking for long-term investments.
- Priority in payment: If a company cannot pay out dividends to all investors, or if they go bankrupt and liquidate assets, preferred stockholders have priority over common stockholders. If a more stable investment appeals to you, preferred stock may be a good fit.
- Risk tolerance: Preferred stocks are typically less volatile and thus less risky, with lower potential gains than common stocks, making them appealing to investors with a lower risk tolerance. You might consider common stock instead if you are less risk-averse or have a longer investment window during which your investment could grow.
- Price: Preferred stock often has a lower price than common stock, and price volatility is usually lower too. Common stock has more potential growth, but stability is lower and share prices can be higher. If you’re looking for an investment at a lower price point, preferred stock may make more sense. If you’re looking for more growth potential, common stock tends to provide higher long-term returns.
- Market conditions: Because they get paid first in the case of liquidation, and prices are more stable, preferred stockholders are at less risk than common stockholders in times of economic uncertainty. Common stockholders, on the other hand, benefit more during economic booms since they see more value when stock prices rise.
How to start investing in stocks
Whether you invest in preferred stock vs. common stock depends on your risk tolerance, investment strategy, and goals. And you don’t have to choose just one; there may be advantages to owning both types as part of a diversified portfolio containing different kinds of stocks, mutual funds, exchange-traded funds (ETFs), and bonds.
When you’re ready to start investing, Stash can make it easy with the Stash Smart Portfolio™, giving you automated investing options tailored to your goals. You can sign up online and become an investor with any dollar amount.
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