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Preferred stock vs common stock, what is the difference between them?

By David Becker

Common shares are great for capital appreciation while preferred are designed for income.

Investors who trade the capital markets can choose from many different types of assets to buy and sell, including different types of shares. The most popular types of equities are common shares and preferred shares. There are several differences between them including the ability to vote on issues related to a company. Additionally, preferred stocks have bond-like features while the underlying price is relatively stable. Active traders generally focus on common stocks as the prices fluctuate providing significant liquidity.

What are preferred shares?

While many investors have a good understanding of common stocks, few have traded preferred shares. Preferred shareholders are higher up on the capital structure relative to common shares. This means that if a company defaults, preferred shareholders will be repaid ahead of common shareholders. Generally, one of the differences between common stock and preferred stock is that the dividends on preferred shares are higher than common shares. The dividends paid on preferred shares are usually monthly or quarterly. The decision to pay the dividend is at the discretion of a company's board of directors. These dividends can be fixed, such as a specific percentage that is paid to the preferred shareholder, or adjustable like a benchmark such as the Prime rate.

Unlike common shareholders, preferred stockholders have limited rights which excludes voting. Preferred stock has debt-like features, in that it pays fixed dividends, but also can experience capital appreciation. This appeals to income investors seeking stability in potential future cash flows.

When you own a preferred share you own a part of the company profits, but if something goes wrong, you are more protected when owning preferred shares. When a company issues stocks and bonds, bondholders are at the top of the capital structure, then preferred shareholders and then common shareholders. This means that if the company defaults or declares bankruptcy, bondholders are the first to retrieve their principal, followed by preferred stocks holders and lastly common shareholders.

If a company is losing money, there is a chance they will suspend its dividend. If this happens, preferred shareholders may have the right to receive payment in arrears before the dividend can be resumed for common shareholders. This type of preferred stock is called cumulative. If a company has made several preferred stock issues, they may be ranked in terms of priority. The highest-ranking is called prior, followed by first preference, and then second preference.

The price of preferred shares are generally very stable and trade within a few dollars of the issue price. They have less of a chance of capital appreciation relative to common shares. Preferred shares can also be callable. This means that the issuers of the shares can purchase them back at par value after a specific predefined date.

For example, if interest rates decline, a company might want to buy the shares back and issue a new set of preferred shares at a lower dividend rate. If shares are not called by their call date, they can continue to trade regularly.

Another feature of preferred shares is that some are convertible, and can be exchanged for a given number of common shares. You might have the option to convert your shares or the board of directors might vote that the shares have to be converted. Whether this is advantageous to the investor depends on the market price of the common stock.

What is common stock?

Common stock represents ownership in a corporation. Holders of common stock have voting rights and can use them to electing the board of directors and to vote on corporate policy. Common stockholders are at the bottom of the capital structure and will only have rights to a company's assets after bondholders, preferred shareholders and other debtholders are paid in full.

The price of common stock will fluctuate with market sentiment. Traders will use several different tools to determine the future direction of common shares. This could include fundamental analysis, technical analysis, and market sentiment.

For a corporation to issue stock, it must begin by having an initial public offering (IPO). An IPO is a great way for a company seeking additional capital to expand. It also is a way for a private company to monetise the value by allowing the public to purchase shares. To begin the IPO process, a company must work with an underwriting investment banking firm which will help determine the initial price of the stock. After the IPO phase is completed, the general public can purchase the new stock on the secondary market.

Preferred vs common stock: Take away

Most of the stocks that are traded are either common shares or preferred shares. Common shares can experience large price moves, and provide investors with voting rights. Some common shares will also pay dividends. Common shares are at the bottom of the capital structure.

Preferred shares are debt-like instruments that pay higher dividends than common shares. The price of preferred shares is usually stable. Preferred shares are higher in the capital structure than common shares and second only to bonds. Most preferred shares do not have voting rights.

If you are looking for income as your main financial goal, then preferred shares are a very good alternative to common shares. If you are looking for capital appreciation, then your best bet is common stocks.

FURTHER READING: What does seasonal analysis say about stock market trends in December and 2020?

FURTHER READING: What times of day can you trade stocks, currencies and crypto?

Like to share your thoughts and ideas about crypto and trading? You could join us as an external author. Email us on [email protected] to find out how you could become a contributor.
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