Preferred stock and common stock are two major types of equity securities that companies issue to raise capital. While both represent ownership in a company, they come with different rights, benefits, and risks. This article provides an in-depth comparison to help you understand their differences and make informed investment decisions.
Definitions of Preferred Stock and Common Stock
Preferred Stock
Preferred stock is a type of equity security that typically offers dividends at a fixed rate and has priority over common stock in the event of a liquidation. Preferred shareholders often do not have voting rights, but they benefit from higher claims on assets and earnings.
Key Features of Preferred Stock
- Dividend Priority: Preferred stocks often pay fixed dividends before any dividends are distributed to common shareholders.
- Liquidation Preference: In the event of company liquidation, preferred shareholders are paid before common shareholders.
- Convertibility: Some preferred stocks can be converted into a specified number of common shares.
- Callable: Companies may have the option to buy back preferred stock at a predetermined price after a certain date.
Common Stock
Common stock represents ownership in a company and entitles the shareholder to voting rights. Common shareholders benefit from potential price appreciation and dividends but are last in line during liquidation.
Key Features of Common Stock
- Voting Rights: Common shareholders typically have voting rights on major corporate issues, such as electing the board of directors.
- Dividends: Dividends are variable and paid at the discretion of the company, depending on its profitability.
- Capital Appreciation: Common stock prices can increase over time, providing potential for significant capital gains.
- Limited Claims: In the event of liquidation, common shareholders’ claims come after creditors and preferred shareholders.
Types of Preferred Stock and Common Stock
Types of Preferred Stock
- Cumulative Preferred Stock: Pays dividends in arrears if missed.
- Non-Cumulative Preferred Stock: Does not pay missed dividends.
- Convertible Preferred Stock: Can be converted into a specified number of common shares.
- Participating Preferred Stock: Allows shareholders to receive additional dividends if the company achieves certain financial goals.
Types of Common Stock
- Class A: Generally provides more voting rights.
- Class B: Typically offers fewer voting rights and sometimes none at all.
- Class C: Often non-voting but may offer other benefits.
Special Considerations in Choosing Between Preferred and Common Stock
- Risk Tolerance: Preferred stocks are generally less risky than common stocks due to their fixed dividends and higher claim on assets.
- Income Needs: Investors looking for regular income might prefer the steady dividends of preferred stocks.
- Growth Potential: Common stocks offer greater growth potential through capital appreciation and are more suitable for investors with a higher risk tolerance and long-term horizon.
- Voting Control: Those interested in influencing corporate decisions might prefer common stocks due to voting rights.
Historical Context
The distinction between preferred and common stocks dates back to the early corporate structures in the 19th century. Preferred stocks were initially introduced as a way to attract investors looking for consistent income with lower risk compared to common stocks.
Examples of Preferred and Common Stock Usage
Example of Preferred Stock
A utility company issues preferred stocks with a 5% annual dividend. Investors who buy these stocks receive consistent dividend payments and have a higher claim on company assets compared to common shareholders.
Example of Common Stock
A technology startup issues common stock through an Initial Public Offering (IPO). Investors who buy these stocks can vote on corporate matters and stand to gain from significant price appreciation as the company grows.
FAQs
What are the main differences between preferred stock and common stock?
Can preferred stock be converted to common stock?
Which is riskier: preferred stock or common stock?
References
- Bodie, Z., Kane, A., & Marcus, A. J. (2014). Investments. McGraw-Hill Education.
- Ross, S. A., Westerfield, R., & Jaffe, J. (2010). Corporate Finance. McGraw-Hill Education.
Summary
Understanding the differences between preferred and common stock is crucial for investors. Preferred stock offers fixed dividends and greater safety, while common stock provides voting rights and the potential for substantial capital gains. Your choice between the two should align with your investment goals, risk tolerance, and financial needs.
By keeping these distinctions in mind, investors can build a diversified portfolio that balances income stability with growth opportunities.
