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

Preferred vs. Common Stock: An Overview

Many investors have heard of preferred and common stock. Both types of stock represent a fractional ownership in a company, and both are tools that investors can purchase to try to profit from the future successes of the business.

However there are differences between preferred and common stock that investors should understand. An important one is that preferred stock shareholders have priority over a company's income, meaning they are paid dividends before common stock shareholders. They are also paid first if a company is liquidated.

Preferred stock usually does not give shareholders voting rights. Common or ordinary stock does, usually at one vote per share owned.

Preferred Stock

Bond-Like Aspects

Preferred stock is a type of security that shares characteristics of bonds and stocks. Like bonds, they provide investors with a predictable flow of income. That's because their dividends are determined when the stock is issued. At the same time, they represent ownership in a company and are traded on an exchange.

Preferred stock has a par value which is affected by interest rates. When interest rates rise, the value of the preferred stock declines, and vice versa. In addition, the price of preferred stock is normally less volatile than the price of common stock.

Preferreds also have a callability feature similar to bonds which gives the issuer the right to redeem the shares from the market after a predetermined time. 

Investors who buy preferred shares have a real opportunity for these shares to be called back at a redemption rate that represents a significant premium over their purchase price. The market for preferred shares often anticipates callbacks and prices may be bid up accordingly.

In case of bankruptcy or liquidation, preferred stock shareholders have a priority claim on a company's assets and earnings. This is also true during the company's good times, when the company has excess cash and decides to distribute money to investors through dividends.

Dividends

As mentioned, preferred stock shareholders are paid their dividends before common stock shareholders (who may or may not receive dividends). If a company misses a dividend payment, it must first pay any arrears to preferred stock shareholders before paying common stock shareholders.

In addition, the dividends for preferred stock are usually higher than those for common stock.

The annual dividend per share is calculated by multiplying the dividend rate by the stock's par value. The dividend yield of a preferred stock is calculated by dividing the dollar amount of a dividend by the price of the stock.

Voting Rights

Preferred stock confers no voting rights. So when it comes time for a company to elect a board of directors or vote on any form of corporate policy, preferred shareholders have no voice about the future of the company.

Common Stock

Common stock represents shares of ownership in a corporation and a claim on profits. It is the type of stock in which most people invest. When people talk about stocks, they are usually referring to common stock. In fact, the great majority of stock is issued in this form. With common stocks, share value is determined by supply and demand.

Voting Rights

Common shares confer voting rights. Investors usually receive one vote per share owned. They vote to elect board members who oversee the major decisions made by management. Stockholders thus have the ability to exercise control over corporate policy and management issues.

Growth

Common stock tends to outperform preferred shares and offers the greater potential for long-term growth. If a company does well, the value of a common stock can go up. But keep in mind, if the company does poorly, the stock's value normally goes down.

Dividends

A company's board of directors decides whether or not to pay out a dividend to common stockholders. They are never guaranteed. In fact, many companies do not pay common stock dividends at all. If a company misses a dividend, the common stock shareholder gets paid after those holding preferred shares.

The claim on a company's income and earnings is most important during times of insolvency. In such a case, common stock shareholders are last in line for the company's assets.

This means that when the company must liquidate, it pays all creditors and bondholders first, then preferred shareholders, and finally, common stockholders.

Differences Between Preferred and Common Stock

The Bottom Line

Preferred stock and common stock can both be attractive securities for investors. While preferred stock may offer a steady source of income compared to common stock, its share price normally has less growth potential.

Common stock shareholders get voting rights while shareholders of preferred stock normally do not. As a result, they can't influence company decisions concerning important matters such as the selection of board members, acquisitions, and stock splits.