Preferred vs. Common Stock: What’s the Difference?

Preferred vs. Common Stock: An Overview

Understanding the differences between preferred and common stock is crucial for investors. The primary distinction is that preferred stock generally does not grant voting rights to shareholders, while common stock usually does, typically allowing one vote per share owned. Both types of stock represent ownership in a company and offer opportunities for investors to profit from the company’s success.

Key Takeaways

• Voting Rights: Preferred stock generally does not provide voting rights, while common stock does.
• Dividend Priority: Preferred shareholders receive dividends before common shareholders.
• Claim on Assets: In case of liquidation, preferred shareholders have a higher claim on assets than common shareholders.

Preferred Stock

Preferred stock is distinct from common stock in several key ways. Primarily, preferred stock does not come with voting rights, meaning shareholders do not have a say in corporate decisions, such as electing the board of directors. However, preferred stock functions similarly to bonds in terms of yield, often guaranteeing a fixed dividend, unlike the variable dividends of common stock.

Dividend Yield: The yield on preferred stock is calculated by dividing the dollar amount of the dividend by the stock price. This yield is usually based on the par value of the stock before it starts trading and can be recalculated as a percentage of the current market price.

Interest Rate Sensitivity: The value of preferred stock is sensitive to interest rate changes. When interest rates rise, the value of preferred stock typically declines, and vice versa.

Priority in Liquidation: In the event of liquidation, preferred shareholders have a higher claim on a company’s assets than common shareholders. They are paid after bondholders but before common shareholders.

Callability: Preferred shares often have a callability feature, allowing the issuing company to redeem the shares after a predetermined period, often at a premium over the purchase price.

Common Stock

Common stock is the most widely held type of stock and represents a share of ownership in a corporation. Common shareholders typically have voting rights, allowing them to influence corporate decisions and elect the board of directors.

Potential for High Returns: Common stock tends to outperform bonds and preferred shares over the long term. It offers the greatest potential for capital appreciation if the company performs well.

Dividend Variability: Dividends for common stock are not guaranteed and can vary. The board of directors decides whether to pay dividends based on the company’s profitability.

Claim on Assets: In times of insolvency, common shareholders are last in line to claim the company’s assets, receiving payouts only after all creditors, bondholders, and preferred shareholders have been paid.

Conversion Option: Preferred shares can often be converted into a fixed number of common shares, but the reverse is not true.

Historical Context

The concept of common stock dates back to the Dutch East India Company, which issued the first common stock in 1602. This type of stock has since become a cornerstone of modern financial markets.

Summary

Understanding the differences between preferred and common stock helps investors make informed decisions. Preferred stock offers fixed dividends and higher claim priority but lacks voting rights. Common stock provides voting rights and the potential for higher returns, but with more risk and variability in dividends. By considering these differences, investors can better align their stock choices with their financial goals and risk tolerance.