Preferred vs Common Stocks: How do they differ?

Many people in America have some basic knowledge about the stock market. At the least, they hear news about stock prices related to some of the world's largest entities.

At the same time, many people have very little knowledge of the availability of various classes of stock and the differences between them.

To keep things simple, the following information focuses on two types of corporate stocks, common and preferred.

We'll define both types of stock and highlight how they differ.

Common Stock

Common stock is by far the most “common” type of stock.

It's the kind of stock most individual investors buy and sell on the stock market through their investment accounts.

A share of common stock represents one share of ownership in the underlying corporation.

Along with that ownership stake, the common shareholder has a proportionate claim against the profits of the company.

These profits could, in turn, be paid out in the form of a declared dividend as determined by the corporation's Board of Directors.

Note: A corporation's Board of Directors has no obligation to “declare” a dividend for common shareholders. They'll typically do so as a means of sharing “extra” profits, which usually results in driving the corporation's stock price upwards.

A Board of Directors can declare a dividend in cash or, in the form of additional stock, a stock dividend.

Common stockholders have proportionate voting rights concerning corporate matters. That would be one vote for every share owned.

If a shareholder owns 100 shares of common stock in an underlying corporation, they have 100 votes they can cast on corporate matters brought before shareholders.

Voting is typically done:

• through the mail
• online
• by proxy (assigning voting rights to another party)
• or during in-person Board of Director meetings open to shareholders and the public

While both common and preferred stock can trade on the open stock market, common stock shares are arguably more volatile.

This is essentially a function of the “fixed-income” benefit attached to preferred stock in the form of guaranteed dividends.

Without the fixed-income component, common stock is more directly vulnerable to the supply/demand forces of economics.

While common stockholders have claims against the underlying corporation's profits, the opposite is true if the underlying corporation faces insolvency and has to liquidate assets.

In such cases, liquidation funds are paid first to creditors, bondholders, and then preferred stock owners.

After satisfying obligations to those groups, any remaining funds can be proportionately distributed to common stock shareholders.

Preferred Stock

A share of preferred stock also represents one share of ownership in the underlying corporation. But unlike common stock, it doesn't provide any claims against the profits of the corporation.

Instead, preferential treatment is given to preferred stock shareholders through a guaranteed dividend.

Companies issue preferred stocks vs. common stocks to obtain equity financing without giving up voting rights.

For the most part, preferred stock acts in much the same way as a corporate bond.

The difference is that the payment to the preferred stock shareholder is called a dividend, while bondholders are paid interest.

The dividend is set by the corporation's Board of Directors when they approve the issuance of preferred stock at a stated dividend.

Dividends are generally paid quarterly to shareholders of record at a predetermined date.

Note: The dividends attached to preferred shares will be paid in perpetuity to the shareholder of record for as long the share remains in circulation.

Since preferred stock dividend payments are often viewed as “interest payments,” the dividend yield is always of primary interest to investors.

The dividend yield can be calculated by simply dividing the dollar value of the dividend by the current stock price, times 100 for the percentage.

The value of a preferred stock, which is issued with a par value, is not driven by market forces. Instead, it's driven by interest rates.

If interest rates rise, the par value of preferred stock will drop or be discounted. If interest rates fall, the par value of the preferred stock will rise as a premium.

In terms of claims against a corporation's assets, preferred shareholders get priority over assets distributed as dividends or during a liquidation.

In fact, a company cannot pay dividends to common stock shareholders until all preferred stock shareholder's claims have been satisfied.

A Bullet Point Look at Common Stock vs Preferred Stock

While defining the attributes connected to common stock and preferred, the difference between these investment options became apparent. Still, it seems prudent to offer a list of the differences in a bullet point format:

• The value of common stock rises/falls based on market forces (supply/demand). Alternatively, the value (par value) of preferred stock shares is driven up or down based on interest rates.

• Common stock dividend income is not guaranteed and is only paid when declared by the underlying corporation's Board of Directors. A preferred stocks dividend payment is established when the stock is issued. It is guaranteed and paid quarterly to the owner of record at predetermined dates.

• Common stock shareholders have proportionate voting rights in corporate matters based on the shareholder's ownership percentage or number of shares owned. Preferred stock shareholders have no voting rights.

• Preferred stockholders get preference over common stock shareholders during distribution of profits or corporate liquidation of funds.

• While a common share cannot be converted to preferred shares, preferred shares of stock can be converted to a fixed number of common shares.

• Preferred stock has a feature called “callability.” Callability refers to the right to redeem preferred stock for a big premium.

How to Buy

You can easily purchase both common and preferred stock through a traditional or online broker.

When a company offers both types of stock, you can tell them apart by their ticker symbols.

Buying Preferred Stock

Before purchasing a preferred stock, be sure to check its credit rating. Those with a higher credit rating (i.e., AAA vs. BB) carry less risk. Like bonds, preferred stocks are rated by Standard & Poor's, Moody's, and Fitch.

You'll also want to review a preferred stock's share price, yield, and callability and whether it is convertible to common shares.

Issuers of preferred stocks tend to be financial institutions such as banks and mortgage companies, realty trusts (REITs), insurance providers, and utility companies.

You can purchase individual shares of preferred stocks, or an easy way to invest in a variety of preferreds is to invest in an exchange-traded fund (ETF).

Final Thoughts

As an investor, the decision to purchase common stock or preferred stock should be made based on your investment goal.

If stock appreciation and the long term growth of your investments is your goal, purchasing common shares of ownership would be the right call. If establishing a quarterly cash flow stream is your goal, you might want to go with preferred stock.

No matter which class of stock you purchase, it's essential to understand what you're investing in and the risks associated with the investment.

Remember to keep your total investment portfolio diversified to help mitigate your risks.

Next:

• Investment Policy Statement (IPS): What it is and how to write
• Government Savings and Investing Products
• Bad Investing Advice: What to ignore [and why]