Common vs Preferred Stock

Fundamentals ·

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There are two main types of stocks on the public market: common and preferred.

Why do we need to have two distinct types of shares and what's the difference between them?

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Illustration by Eugene A

In this article, we'll take a look at these two types of stocks (shares) to figure out which one would be a better choice for an investor.

What is Common Stock?

As the name suggests, common stocks (also known as voting shares and ordinary shares) are the most basic and simple type of shares that a publicly traded company can offer. Most ticker symbols you see represent common stocks and if it's not the case, it'll be mentioned in the asset name.

Typically, common stocks give their owners some voting power as well as the right on the share of company's profits. Some common stocks pay dividends but they are often smaller than the dividends that a preferred stock would pay.

Common stocks usually offer a lower initial dividends yield than preferred ones.

Generally speaking, most of the stocks and shares you hear about on the TV or in movies are the common ones and they have the biggest trading volume because they are designed to have a broader distribution than preferred stocks.

What is Preferred Stock?

Preferred stocks are much more complex than the common ones as they may have a number of unique features.

Unlike common stocks, preferred stocks (preferred shares, preference shares or simply preferreds) usually don't provide any voting rights on shareholders’ meetings regarding management decisions. However, they usually offer higher dividend payments which are often fixed.

In addition to that, owners of the preferred stocks have a priority in receiving any dividend income over those who own common stocks. Owners of the preferred shares get their income first and, if there is something left, the rest of the dividend income goes towards holders of the common shares. However, the dividends for the preferred stocks are not guaranteed as they are paid from the company's after-tax profits, which makes them different from more “for sure” income generating assets such as bonds.

If the company shows a deficit (no net income) in its annual report or if the firm has cash issues, its shareholders most likely won't receive any dividends unless those preferred stocks are “cumulative”.

Dividends from preferred stocks can sometimes be cumulative, but they are never cumulative for common stocks. In this context, “cumulative” means that if shareholders didn't receive dividend payments when it's required, the company will have to pay those dividend “debts” in the future.

Noncumulative stocks are called “straight”.

Preferred stocks are superior (senior) to common stocks, but bonds have even higher priority when it comes to debt payments. If a company is to declare a bankruptcy then all of its possessions are for sale in order to pay off the debts. Bondholders get the first payments, then the holders of the preferred stocks and, lastly, the holders of the common stocks, assuming there is anything left at that stage.

These stocks are called preferred mostly because of the priority/preference in the event of liquidation and the priority in the dividend payments.

These stocks are rated by credit rating companies (i.e. Standard & Poor's and Moody's) as bonds, but they usually get lower ratings.

In most cases, preferred stocks have a lower volatility than the common ones.

Some preferred stocks would have a feature that allows their holders to convert them into common stocks. In this case, they are called “convertibles”.

These stocks may or may not have a liquidation value. This is a fixed value that derives from the initial purchasing price, it guarantees the shareholders that they will get some capital back for sure if they decide to liquidate their assets (preferred stocks).

Preferred stocks can be “callable”, which means that they are redeemable as bonds with a specific date and a price at which they can be redeemed.

In the United States, government gives certain tax benefits to those corporations (not individual investors) that purchase preferred stocks. That is one reason why the majority of preferred stock is bought and held by large institutional investors.

All these features are helpful for those investors who are willing to risk their capital by investing into a company at an early stage of its development (startups, etc.) so they can get certain additional benefits.

In terms of the income and risks, preferred stocks are somewhere between common stocks and bonds: they are riskier than bonds, but they have higher potential returns. However, common stocks are often better in terms of the potential financial gains.

Summary

Here is the summary of the main differences between common and preferred stocks:

  • Liquidity (Common/Preferred): high / low
  • Voting rights: yes / no
  • Fixed dividends: no / yes
  • Tax burden: low to medium / low in some cases
  • Initial yield: low to medium / high
  • Cumulative dividends: no / sometimes
  • Dividends growth: yes / no (rarely)
  • Price volatility: medium to high / low to medium
  • Convertible: no / sometimes
  • Debt payment preferences: no / yes
  • Liquidation value: no / sometimes

Who Should Buy Common or Preferred Shares?

To understand what kind of stocks is better to buy, it's important to know that preferred stocks can be different. That's why when we mentioned their typical features we often say that a feature is “often”, “sometimes” or “almost always” present.

The preferred shares differ from one company to another and their features depend on their initial design and purpose. Many companies don't issue preferred stocks at all and certain companies give some of the preferred stocks’ features to the common stocks.

One shall read the terms of the preferred stock in the issuing company's articles of association or articles of incorporation to learn more about it. In some cases a company may issue several preferred stocks with different rights, such as Series A Preferred, Series B Preferred, etc.

The number of preferred stocks that are publicly traded can be limited or they might not even be available for the public at all. Some companies give their preferred stocks to its employees or allow them to purchase them with a discount to reward/motivate them.

It's interesting that the price of preferred and common stocks often behaves in a similar way because it's the same company after all, but the volatility differs as well as the trading volume. As a general rule, it might be better to go with preferred stocks if you're a person who prefers a slow buy-and-hold conservative investing approach and a long-term strategy with passive return from dividends. Active traders might be better off with more volatile common stocks.

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