Preferred Stock Vs. Common Stock – Differences With Examples
Preferred stock vs common stock is one of the most sought after topics related to stocks. In stock trading, you have to understand the difference between preferred stock and common stock.
Stocks are shares in a company that gives the stockholders a part of the ownership of that company. So when you buy or invest in stocks of a company, you own a part of the company.
If the company you invested your money in increases in value, the value of the stock you invested in increases. Similarly, if the company performs poorly and loses money, it’s stock value will dip naturally.
Owning stocks earns you voting rights for that company. That means you can take part in the company decisions and give your vote to choose the company’s board of directors. You will also receive quarterly and annual reports of the company indicating its performance over some time.
The way stocks are valued depends on many factors. But primarily, the prices are determined by the supply and demand of the stock. If more people are buying the stock instead of selling it, its price will increase. The vice versa happens when more people are selling rather than buying.
We discussed the basics of stock so it will be easier for you to understand the main topic of discussion in this article: preferred stock vs common stock.
These are the two types of stock and we will discuss their features and the way they are inherently different from one other. Let us first understand what preferred stocks are.
What Is Preferred Stock
Preferred stock is the type of stock where stockholders get special privileges in the sense they get priority over common stockholders when it comes to receiving dividends.
The dividend is the amount that the company pays to its shareholders out of the profits it earns. It is a way of distributing the revenue back to the company investors. Dividends are paid either quarterly, semi-annually, or annually.
Thus when the company distributes its profits, preferred stockholders are the first ones to receive it instead of common stockholders. This is why preferred stocks are referred by this name.
However, the dividend they receive is fixed. This means the potential profit/reward from preferred stock is lesser than common stock. But this also makes it less risky than common stocks.
Another distinct feature of preferred stock is that preferred stockholders don’t enjoy voting rights or have a say in how the company runs.
There are 5 types of preference stock: Cumulative, Participating, Convertible, Callable, and Adjustable-rate. These are discussed in our article: types of preferred stock
Preferred stockholders also enjoy arrears. If for any reason, preferred shareholders don’t get paid their dividends in a year, they get paid the arrears the next year. This is also a unique property of this shareholder.
Note that not all companies issue preferred stock. Companies usually roll out these stocks because they too enjoy certain benefits.
Issuing preferred stocks lower’s the company’s debt-to-equity ratio as these stocks serve as equity rather than debt. Another reason for selling preferred stocks is that they can suspend the dividend payment in the case of a financial disaster.
Finally, the preferred shareowners don’t have any voting rights and just paid a fixed amount. This makes issuing preferred stock favourable for the company.
Other than the higher claim on dividends, preferred stock owners also get higher priority to claim assets in the case of liquidation.
In a way, the preferred stock carries the features of both bonds and common stock. It is a hybrid of common stock and a bond in essence.
- When you own preferred stock, you receive dividends like common stockholders. In this way, it is similar to common stocks.
- Preferred stockholders receive fixed dividends. It doesn’t matter if the company goes through profit or loss; it has to pay the dividend to these stockholders. In this way, it is similar to bonds.
If you are wondering about the dividend rate that preferred stockholders receive, it lies between 5%-7% usually. Let us understand the dividend amount through an example.
Example Of Dividend Payout In Preferred Stocks
For example, you purchase 100 preferred shares of company A. Each share is valued at $40. Hence, the total value of these shares stands at $4000. If the dividend rate is 5%, you get $200 as fixed dividends.
Now if the value of share decreases to $35, you still get $200 in dividends. You might think this is beneficial for you, but what happens when the stock value increases.
Consider the following situation: The stock value this company drastically increases to $60 during a massive bull run. In this case, you will still get the same dividend amount instead of it being increased.
In this case, you are missing out on potential profits that common stockholders will enjoy. You are sacrificing profitability for reduced risks.
What Is Common Stock?
Common stock is the most common types of stock that a company issues. A company issues stocks to fund their initial expansion and operation costs.
Any company that issues stock needs to become a public company. When anyone buys stocks of a company, they own a part of that company.
For example, if there are 100,000 stocks of a company, and you purchase 100 stocks, you own 0.1% of the company.
The way a company gathers public funding is through an Initial Public Offering (IPO). IPO is the act of selling the initial few shares of the company to the public to cover the costs of company growth and development.
Consider the example of Mark. He wants to expand his electronic shop on a massive scale. He decides to go for an IPO. The bank evaluates his business and determines the total value.
From this value, the number of shares and the price per share is calculated. Keeping some of the shares for himself, he issues the rest of the shares to the public.
Once the public buys the share, Mark uses this money to grow and fund his business. If his company performs well, the value of the share will increase.
This depends on the demand and supply of the share. IPOs work as a great alternative to lengthy bank loans. In the best-case scenario, it is a win-win for both business owners and investors.
The features of common stocks are different from preferred stocks. Common stockholders are owners of the company; hence, they can exercise their vote on company elections and decisions.
They also receive dividends but it not fixed like preferred stocks. They receive dividends when the company makes profits.
Not just that, they receive dividends only when the company pays out its loans and pays out the preferred shareholders and ends up with a profit.
Even in the case of liquidation, they receive money after the liabilities and preferred shareholders have been paid off.
If the company they invested in performs well, they have the right to sell the stocks at a higher price than they bought.
The amount of dividend received increases as the price of the stock increases and vice versa. Therefore, you must invest in well-performing companies that are expected to grow in value and size.
There are a lot of factors that affect the value of stocks but that topic is outside the scope of this article.
Example Of Dividend Payout in Common Stocks
Sam purchases 100 common stocks of company B, where each stock is valued at $10. He buys 1000 stocks with a dividend rate of 7%.
If the value of the stock remains the same, the dividend amount would be $700. If the value of stock increases to $12 per share, the dividend amount would increase to $840. Similarly, if the stocks drop to $8, the dividend amount would decrease to $560.
Thus, the dividend amount is directly linked to the price of the underlying stock.
Preferred Stock Vs Common Stock – Key Differences
As we mentioned before, preferred stock vs common stock article is necessary for all types of stock traders.
At the very first, we have understood the concepts of preferred and common stock. We can now take a look at the differences between these two types of stock.
They are separated by certain unique features that are discussed here:
1. Rarity:
As the name suggests, common stock is far more prevalent than preferred stock. Not all companies issue preferred stock. Any company listed on the stock exchange issues common stock.
2. Voting Rights
Preferred stockholders don’t enjoy any voting rights in the company that they invest in. On the other hand, common stock owners can exercise the rights to company decisions.
3. Priority:
Preferred stockholders get their dividends paid before common stockholders.
4. Nature Of Dividend Payment:
For preferred stockholders, the payment is fixed and is on fixed intervals. Common stockholders don’t always receive dividends. It depends on the profit level of the company.
5. Arrears:
Common stockholders don’t receive arrears in the following year. Contrarily, preferred stockholders receive arrears in the following year.
6. Earnings:
Earnings are fixed for preferred stocks. However, there is no limit for dividend payments for common stocks.
7. Redeemability:
Common stocks cannot be redeemed by the company that issues it. Preferred stocks, on the other hand, can be redeemed once the stocks reach the end of the maturity period or whenever the company wants to buy it back.
8. Convertibility:
Common stocks cannot be converted to any other stock class or form. On the other hand, preferred stocks can be converted to common stocks or debt.
Final Words
In this article, we learned the key differences between common stocks and preferred stocks. The primary difference lies in the payment of dividends.
However, there are other differences that make it different from each other. In order to understand their differences, we need to understand each of the stock types first.
Hence, we explained each of the stock type and an example of how dividends are paid in each case. Finally, we listed the key differences between the two.
Now that you know the differences, you know which type of stock suits your investment style. To conclude, whether you go for common or preferred stocks, you need to invest wisely and carefully to make the most of your investment.
