Common Stock vs. Preferred Stock

Stock investors can choose from thousands of companies across various sectors. However, some investors may not know that they can also choose between common and preferred stock. While common stock is more accessible to retail investors, it is also possible to get preferred shares. Understanding the differences between these two shares can help you make better choices for your portfolio.

What Are Common Stocks?

Common stocks fulfill the widely held definition of owning a stock. Common shares let you own a small piece of the company and accumulate wealth if the company performs well. Your shares can appreciate over time, and some stocks also offer dividends. Shareholders can vote on issues related to the company, such as deciding on a new board member.

What are Preferred Stocks?

Preferred stocks do not offer voting rights, and your potential returns have a lower ceiling. Preferred shares are a hybrid of stocks and bonds. These shares have higher yields than common shares and get priority for a dividend. It’s possible for preferred shareholders to receive dividends even if common shareholders do not receive dividends. In some cases, preferred shares can get exchanged for common shares at maturity. The investor’s return is capped to the preferred stock’s par value plus dividend payments.

Differences Between Common Stock and Preferred Stock

Common stock is riskier than preferred stock but can generate higher long-term returns. Preferred stocks are more optimal for risk-averse investors who want steady cash flow. Preferred stock is similar to a bond, and some preferred shares can get converted into common shares at maturity. 

Preferred shares cater to investors with lower risk tolerances who want to generate more income. Preference for dividend payouts and concerns about bankruptcy proceedings give preferred share investors extra safeguards. People approaching retirement may want to consider the higher safety of preferred shares compared to common shares. Investors seeking a higher possible return while accepting more levels of risk may benefit more from common stock vs. preferred stock. 

Voting Rights

Voting rights are a key difference between common and preferred shareholders. Common shareholders can vote on important matters like electing the board of directors. This ability allows them to influence the company's direction. Preferred shareholders, on the other hand, do not have voting rights. They cannot take part in decisions that affect management or strategy. Although they have benefits like fixed dividends and higher claims on assets during liquidation, they cannot influence corporate governance. Thus, common shareholders play an important role in shaping the company’s future. Preferred shareholders, despite their financial benefits, lack a say in key decisions. They must trust management and the board for their interests.

Dividends

Dividends are part of a company's earnings paid to shareholders. They can differ between common and preferred stock. Preferred stock pays fixed dividends regularly, making it a stable choice. These dividends are cumulative. If a company misses a payment, the unpaid amount must be paid before common stock dividends can be issued. Common stock dividends vary. They depend on the company's profits and board decisions. Common shareholders may receive dividends when the company is profitable, but these are not guaranteed. They can be reduced or suspended if the company struggles financially. Preferred stockholders enjoy reliable payments, while common stockholders face more uncertainty.

Claim on Assets

In a company's liquidation or bankruptcy, different stakeholders have varying claims on assets. Bondholders have the highest priority. They are paid first from the company's assets and usually recoup their full investment and interest before others are paid. Next are preferred shareholders. They receive payment after bondholders but before common stockholders. Preferred shareholders typically get fixed dividends. However, if assets are insufficient, they may not get back their full investment. Common stockholders are last in line. They are paid only after bondholders and preferred shareholders. This means they carry the greatest risk, as they might receive little or nothing if the company's assets are exhausted.

Understanding this hierarchy is crucial for investors, as it influences risk assessments and potential returns within their investment strategy.

Should You Choose Common Stock or Preferred Stock?

Investors need to assess key factors when choosing between common and preferred stock. Common stock offers voting rights and potential growth. It attracts those looking for long-term gains. However, it involves more risk, as common shareholders are last to be paid during liquidation. Preferred stock, on the other hand, gives fixed dividends and higher claims on assets. This makes it a better fit for risk-averse investors who want stable income. Understanding these differences, along with your investment goals, risk tolerance, market conditions, and the company's specifics, is essential for making a smart decision. This analysis helps investors choose the right stock type for their portfolio.

Common stock and preferred stock have strengths and weaknesses. These factors can help you decide which type of stock makes the most sense for your portfolio.

Risk Tolerance

Investors' risk tolerance influences their decision between preferred and common stock. Those with low risk tolerance often choose preferred stock. It offers fixed dividends and a higher chance of getting their money back if a company fails. This stability appeals to conservative investors who want consistent income with less volatility. In contrast, common stock attracts those willing to take more risks. It does not guarantee dividends and is more volatile during market shifts. However, common stock has the potential for significant gains. Investors may accept this risk for higher returns, especially when a company grows. In summary, preferred stock suits risk-averse investors looking for steady dividends and security. Common stock is better for those okay with volatility and seeking long-term growth. Each option reflects an investor's risk tolerance and guides their investment choices.

Cash Flow

The company’s cash flow has changed notably over the past year. Cash inflows have risen significantly due to increased sales and better collection processes. However, cash outflows have also grown because of higher operational costs and technology investments. Despite these expenses, net cash flow remains positive, showing good financial health. This positive cash flow is important for growth. It allows the company to reinvest in operations and improve efficiency. It also helps the company seize market opportunities. Keeping a balance between inflows and outflows ensures liquidity. This enables the company to meet its obligations and reduce debt. Compared to industry benchmarks, a positive cash flow is key. Many competitors face cash issues, which gives us an advantage. Overall, good cash management strengthens our financial position and prepares us for future growth and competitiveness.

Voting Rights

Voting rights are important in corporate governance. They allow shareholders to influence key management decisions. Common shareholders have these rights and can vote on major issues, like electing the board of directors. This gives them a say in the company's direction and oversight. Preferred shareholders do not have voting rights, even though they own shares. They cannot vote for directors or influence company policies. This limits their control over important decisions. Preferred shareholders do receive fixed dividends and have a higher claim on assets if the company is liquidated. However, they lack voting power, which sets them apart from common shareholders. The difference in voting rights can impact corporate governance. It may result in common shareholders prioritizing their interests over preferred shareholders, who cannot participate in governance. Recognizing these distinctions helps understand the relationship between common and preferred shareholders.

Market Conditions

Current market conditions are shaped by various economic factors. Recent trends show that consumers prefer sustainability and value. This shift has increased demand for eco-friendly products. As a result, suppliers are changing their offerings, which affects inventory levels and prices. Inflation is also affecting consumer spending. Rising prices on essential goods make it harder for people to buy non-essential items. Businesses are facing higher production costs and need to stay competitive on pricing. Supply chain disruptions from the pandemic continue, making product availability inconsistent. Overall, some sectors like technology and healthcare are doing well, while retail struggles to grow. Looking ahead, companies that adapt to changing consumer preferences will perform better. Innovation and cost management will be key to staying competitive in this volatile economy.

Company-Specific Factors

Company-specific factors influence the ownership dynamics between common and preferred stockholders. Key areas affected include shareholder rights, dividend distributions, and voting power. First, a company's capital structure is important. Companies with a lot of preferred stock often prioritize preferred dividends. This may delay dividends for common stockholders if the company faces financial issues. Second, corporate governance policies impact shareholder rights. Common stockholders typically have voting rights, allowing them to influence management. Preferred stockholders usually do not have these rights, which can create a power imbalance. Finally, a company's financial health impacts dividend distributions. Companies that reinvest profits may cut or skip dividends. This can frustrate common stockholders. Preferred stockholders, however, receive fixed dividends, making their returns more stable. These factors shape the relationship between common and preferred stockholders and show how company decisions affect shareholders.

Frequently Asked Questions