Preferred vs. Common Stock: Key Differences

When it comes to investing in the stock market, two primary types of shares are often discussed: preferred stock and common stock. Each type of stock has its own set of characteristics, advantages, and disadvantages. Understanding the differences between these two can help investors make informed decisions about their portfolios.

Dividend Payments

Preferred Stock: Preferred stock typically comes with a fixed dividend rate, which means that investors receive a predetermined amount of dividends regardless of the company's performance. These dividends are usually paid before those of common shareholders and can be cumulative or non-cumulative. In a cumulative structure, if a dividend is skipped, it accumulates and must be paid out before common shareholders receive any dividends.

Common Stock: Common stock does not guarantee a fixed dividend. Instead, dividends are paid at the discretion of the company's board of directors and may vary from year to year. This means that common shareholders do not receive a stable income stream like preferred shareholders do.

Voting Rights

Preferred Stock: Preferred stock often comes with limited or no voting rights. This is a significant distinction from common stock, which typically carries voting rights. However, some preferred stocks may have higher voting rights, especially voting preferred shares, which can give their holders greater influence at shareholder meetings.

Common Stock: Common stockholders generally have the right to vote on important company decisions, such as electing the board of directors and approving major corporate actions. This gives them a significant say in the management and direction of the company.

Liquidation Preferences

Preferred Stock: In the event of a company's liquidation or acquisition, preferred shareholders typically receive their investment back before common shareholders. This is known as the liquidation preference. Senior preferred stockholders are first in line, followed by pari passu (equal) preferred stockholders, and then junior preferred stockholders. This ensures that preferred shareholders are protected in the event of financial difficulties.

Common Stock: Common shareholders are subordinate to preferred shareholders in liquidation events. They receive any remaining proceeds after all preferred shareholders have been paid. This means that common shareholders bear the risk of not receiving any residual value if the company goes into liquidation.

Redemption

Preferred Stock: Some preferred stocks are redeemable, meaning that the company can buy them back from shareholders within a specified period or under pre-agreed conditions. This provides a financial guarantee to investors, ensuring they receive their initial investment back.

Common Stock: Common stock is not typically redeemable. Companies may repurchase their own common stock, but this is not a guarantee and is usually done to reduce the number of outstanding shares or to return capital to shareholders.

Risk and Volatility

Preferred Stock: Preferred stock generally offers a lower risk profile compared to common stock. The fixed dividend and liquidation preference make it a more stable investment. However, preferred stocks can still be volatile, especially during market events that affect the financial sector.

Common Stock: Common stock carries more risk and volatility. The value of common stock can fluctuate significantly based on the company's performance and market conditions. Investors may lose their investment if the stock price declines.

Conclusion

Preferred stock and common stock differ significantly in terms of dividend payments, voting rights, liquidation preferences, redemption options, and risk profiles. Preferred stock offers a more stable income stream and protection in liquidation events, while common stock provides voting rights and the potential for higher returns.