Common Stock vs. Preferred Stock: What’s the Difference?
When companies raise capital through equity investments and have two main options- common stock vs preferred stock. In exchange for capital, investors receive a stake in the company’s stock and a share in profits. This takes the form of appreciation or dividends (whose amount and payout date differ) based on the kind of stock owned.
There’s an increasing number of start-ups looking to enter the market and expand their capitalization, so new stock offers are likely to multiply. The question is, how should you participate in different equity classes on the stock exchange?
Stocks have three main benefits. First, stock returns have historically been better than fixed-income investments (bonds), so you’re likely to gain more with common or preferred stocks. Second, you can diversify your income streams and reduce risk by adding passive income- where you potentially earn more for working less. And lastly, stocks nowadays offer you the ability to start small so that regardless of your current financial standing, you can start to gain all of these benefits and more.
Now that you understand the benefits of stocks, should you be investing in common or preferred stocks?
Overview: Common Stock vs. Preferred Stock
Regardless of what type of stock you choose, both offer an ownership stake in a company and are an instrument to profit. Owning either of these types of stocks allows you to participate in the stock market by investing in companies.
This is where the similarities end. While both represent ownership and gains, the exercise of control and the amount of profit differ.
When traders and investors refer to investing in stocks, they usually mean investing in common stocks, as common class shares are the most prevalent in the stock market. This is because, in most cases, preferred shares comprise only a small percentage of a company’s equity issues. Therefore, it’s imperative to learn about what the most common type of stock in the stock market and what it entails.
Common shares are unique in that ownership rights extend to voting rights, allowing common shareholders to drive corporate decisions. This includes the ability to elect a company’s board of directors, pass company policies, and weigh in on management issues. The weight of your voting rights depends on the number of common shares you own, as one stock is equal to one vote.
Advantages of Common Stock
- Common stocks grant voting rights: Voting rights are important for holders to relatively control the performance of a company according to their strategies and preferences. This allows for greater transparency and accountability as investors participate in major corporate decisions and can directly influence its leadership by electing a company’s board of directors.
- Take advantage of a growing market with unlimited growth potential: Rather than only dividends, the benefit of common stocks is derived from the performance of the market. If you evaluate long-term growth, common stocks often outperform bonds and deposit certificates. In a high-growth potential industry, corporate earnings continuously increase, and common stockholders receive higher returns.
- Leverage: If your stock gives high returns in relation to the previous benefit, you can use the common stock as collateral for a loan or a line of credit. The reason why this is effective is because of how liquid this financial asset is compared to other alternatives like real estate. Since the value of this asset tends to increase, it may even be possible to secure lower interest rates when using it as collateral upon purchase.
- Deferred taxes on capital gains: While the capital gains for common stocks are high, the taxes don’t have to be. Shareholders are not required to pay taxes until the stock is sold.
Main Disadvantage of Common Stock
A major disadvantage to common stock is how the stock may starkly decrease in value with the volatile market. Where it derives its gains is also where it could potentially lose without a dividend payment to cushion the impact.
Common shareholders are any individual or entity that are holders of common stock in any company. They enjoy all the benefits that come with common stock and are given ownership stake so long as they have ownership of the stock. Dividend payouts can still be given to common shareholders in cash or stock payout if the company declares a common dividend. However, this benefit of guaranteed dividends is afforded only to preferred shareholders.
Companies do not issue as much preferred stock as they do common stock. But, when companies do, they do so because of their long-term growth strategy. By decreasing their debt-to-equity ratio, they can secure more financing from new investors. Companies can also call a preferred stock at par value to avoid a stark increase in interest rates. The benefits extend to preferred stockholders as well since preferred shares offer consistent dividends compared to common stock and higher returns than bonds. While preferred shareholders do not have voting rights, they enjoy advantages as exclusive as the number of shares issued.
Advantages of Preferred Stock
- Fixed dividend payments: Regardless of the preferred stock’s trading share price, a dividend payment is unaffected as the par value is used as the basis. Preferred stock may offer a stable cash flow in your portfolio, and timely payouts as preferred stockholders receive dividends first every time companies offer dividend payouts.
- Transparent liquidation value: Preferred stockholders are aware of the liquidation value of the preferred stock in the company’s worst-case scenario. Even as a failed investment, holders can still claim the indicated amount.
- Higher priority access to assets: If a company goes bankrupt, the preferred stockholders are ahead of common stockholders in receiving the company’s liquidated assets.
- Convertible preferred stocks: Preferred shareholders can take advantage of the appreciation of common stock by converting preferred stocks into a fixed number of common ones. On the converse, converting common stocks into preferred ones is not possible.
Main Disadvantage of Preferred Stock
The primary disadvantage is the lack of voting rights that common stockholders enjoy. Holders may enjoy the dividends now but are capped on how much capital appreciation preferred shares can increase. Preferred share prices are generally limited by their redemption value, in this way, they are somewhere in between common stock and a corporate bond based on risk and reward potential.
Preferred Shares vs Bonds
Preferred shares are like a bond in that they are issued with a set face value or par value. Moreover, if companies go bankrupt, bonds and preferred stockholders come before common stockholders.
Bonds are debt securities where holders don’t have any prospect of equity or convertible equity with future voting rights. Preferred stocks, on the other hand, receive preferential tax treatment with lower interest rates than bonds. This occurs because preferred stock pay qualified dividends, which are taxed at long-term capital gains rates. However, bond coupons are taxed as interest, which is taxed at ordinary income rates.
Preferred shareholders are any individual or entity granted preferred stock. The differences between common and preferred shareholders can be seen in the seniority of the asset, such as the latter’s higher claim on distributions.
Common vs Preferred: What’s The Difference?
Investors may want to receive dividends over the potential earnings and appreciation of common stock because of how volatile the stock market can be. Instead of betting for the highest value, investors may opt for the safer option of an average yet constant income.
Common stockholders receive dividends depending on the company’s profitability. Common stock dividends are not guaranteed, unlike preferred stockholders. Moreover, dividend yields for preferred stock are much higher than the dividends for common stock. The latter’s dividends can change or can potentially be cut entirely.
If you are a high-yield dividend investor, preferred stock may be better suited for you. In terms of the hierarchy of payments, preferred stockholders have priority over a company’s income, so they get paid dividends before common stockholders if the company suffers hardship and needs to cut distributions, common stockholders will suffer.
The hierarchy of preferred over common remains true if a company faces liquidation. Common stockholders do not receive any asset before creditors, bondholders, and preferred stockholders are paid. So, if a company goes bankrupt, there is a potential of common stockholders not receiving anything at all.
Venture capitalists prefer a company that offers liquidation preferences such as 1X, 1.5X, or 2X classes. This means that for every dollar, the preferred stockholder receives 1, 1.5, or 2 times the amount upon liquidation.
Which Is Safer?
Preferred stock and common stock both have risks as they operate in the same market and are generally not for those who have low-risk appetites. But, preferred stock is generally less risky because it has a constant factor amidst a fast-paced market, dividend payments. Moreover, even in the worst-case scenario, these dividends are secured for bondholders and preferred stockholders before common ones.
Which Is Better?
What is preferable depends on the factors you place the most value in. Consider the following and rank them according to your priorities:
- Earning Potential: The price and returns for common stock can increase exponentially and unlimitedly, while preferred stocks have a ceiling dictated by the redemption value.
- Dividend Distribution: Common stockholders are not guaranteed this extra income, while preferred stockholders receive it at a fixed rate.
- Risk of Failure: There is a risk of losing all your money with common stock. While this can also happen for preferred ones, it’s much less likely. Additionally, if the company falls, you will have received some (or all) of your initial investment back in the form of paid dividends.
- Voting Rights: One of the major advantages of common stock is the ability of holders to control major decisions and leaders, which does not exist for preferred stockholders.
- Claim to Earnings: If you’re one to prepare for the worst case, preferred stockholders are protected by the hierarchy of the claim to earnings. You may not get the full investment back, but in liquidation, you will be guaranteed more than common stockholders who are paid last in line.
If your objective is to increase earnings exponentially, regardless of the risks, common stock is for you. If market risk sounds daunting (or you are just looking for reduced exposure), preferred stocks can be a fitting asset in any portfolio.
However, if the regular dividend payments fit your financial goals over long-term appreciation, then common stocks may not be as attractive as preferred stocks. One possibility is to acquire common stocks of growth companies that have high growth potential and preferred stocks of mature companies- to enjoy the benefits of both.
Ultimately, what is better is the option that addresses your financial needs.
Both common stock and preferred stock have their own unique benefits and, of course, distinct risks. Which benefits are more attractive and which risks are more suitable for your investment preference depends on your financial plan, portfolio, and, ultimately, your targets and goals of financial success.
Josh is a financial expert with 15+ years on Wall Street as a senior market strategist and trader. Josh graduated from Cornell University with a business degree in Applied Economics and has held numerous U.S. and European securities and brokerage licenses including FINRA Series 3, 7, 24, & 55. In addition to running an investment and trading firm, Josh is the founder and CEO of Top Dollar, where he teaches others how to build 6-figure passive income with smart money strategies that he uses himself.