5 Key Differences Between Preferred and Common Stock

Preferred stocks typically provide fixed dividends and no voting rights, prioritize payout in liquidations, and may be callable. Common stocks offer variable dividends, voting rights, and potential for significant capital gains.

5 Key Differences Between Preferred and Common Stock

Voting Power

Publicly traded companies are governed by the common shareholders who have the ability to vote for a specific decision . In most cases, each share of common stock entitles a shareholder to one vote for a company decision. As a result, such shareholders vote for directors of the company every year. For example, Apple Inc. decides to enter a new market by opening a new factory to be located in a developing country. The business unions demand 1 million shares at $105 per share. The common shareholders hold the privilege to vote on this proposal.

Preferred stock is not the case and does not provide a vote, much like any form of debt instrument . This is meant to appeal to investors who require the assurance of a fixed income and choose not to want to participate in the company’s functioning. These shares do not carry voting rights, and, as a result, upon separation, these shareholders gain dividends before mainstream shareholders but are no longer entitled to voting. For example, only common shareholders had the power to vote during Ford Motor Company’s previous board election. The related transactions may not afford to offer this payment since the purpose of these shares is to provide a stable source of income rather than control over the company.

Here, we see the first trading party making a trade-off, where one benefit comes at the expense of the other. As a result of not having these investment constraints, investments that will result in higher financial stability will be held by preferred shares.

Dividend Policies

Due to the fixed dividend rate, preferred stocks appeal to income-seeking investors. Common stocks offer dividends that are declared based on the recommendation of the board and can be reinvested into the company .

In contrast, preferred dividends are typically agreed upon in the by-laws and paid first before the common shareholders . Holding a preferred stock at a rate of 5% and a par value of $100, the holder is guaranteed $5 per share every year despite the corporation financial performance, provided that the company maintains its liquidity .

For example, the Coca-Cola Company paid $1.64 in dividends in 2020, $0.04 more than the year before . Such case and the healthy dividend growth over time indicate a profitable period. This decision reflects that the common dividends may vary annually, but hefty common dividends are possible when a company is on the revenue-generating path.

At the same time, when the financial crisis hit in 2008, many banks stopped paying out dividends for preferred stocks. The decrease in common dividends was massive, unlike the case of preferred common . This example and numerous events of the same kind indicate that preferred stocks dividends remain safe in the event of a crisis.

Liquidation Hierarchy

Liquidation preference is an advantage given to preferred shareholders in the event of a company’s dissolution. It allows holders of preferred stock to receive their investment money first or before the common shareholders. Liquidation means that the company is unable to pay its debt or becomes bankrupt, and to repay the funds, it is liquidated .

As such, readers should know that preferred shareholders have the right to be paid first when a company dissolves, and only if there’s anything left can be shared among common stockholders.

To illustrate this better, it is important that a hypothetical company is used. Consider Tech Innovations, a company that has become bankrupt. After paying all creditors and bondholders, Tech Innovations has $1 million realized in liquid assets.

If the preferred shareholders amount to $600,000, this amount will be given to them first. The common stockholders will receive the remaining $400,000. In most cases, the common stockholders will receive an amount that is significantly lower on a per share basis compared to the first class of shareholders. Investors should understand that this practice applies because common shareholders have higher risk tolerance levels, which means they could lose the investment cash. During the Lehman Brothers’ bankruptcy in 2008, the preferred shareholders were able to recover a higher average percentage of the investment capital compared to the common shareholders.

Yield Comparison

First and foremost, it should be noted that preferred stocks often offer higher, more stable yield compared to common stock, a characteristic that appeals to a significant number of risk-averse investors looking for a certain level of predictability with respect to their returns. Let’s have a closer look at this using the actual company data. For example, if the company is JPMorgan Chase, then the preferred stock might offer the fixed dividend yield of around 6% based on the par value of $100. Meanwhile, the company’s common stock yield has been fluctuating around 2.5-3% in the past years so far.

It is clear that this difference in yield is not incidental but rather a fundamental characteristic of preferred and common stocks’ financial structuring. In particular, preferred stocks are structured in order to offer higher dividends to stockholders, which are also paid before any dividends are ever paid to common stockholders. This system is put in place in order to compensate the lack of voting rights that shareholders get as well as the lower level of potential capital appreciation.

Let’s have a look at a more concrete example using the dividend payout for the fiscal year. Say, the company paid $1 million. Meanwhile, there are 100,000 shares of preferred stock outstanding. Each of them gets a $6 dividend rate per share, totaling $600,000 of dividend for the preferred stocks. Subsequently, the remaining dividend amount of $400,000 is divided among the common shareholders, of which there are 1 million. It follows that each of the common stock shares will yield $0.40 worth of dividend, making it a 3% yield given the market value of the stock is $13.33 . This is the essence of the key tradeoff that is made: higher, fixed, guaranteed yield for preferred stockholders as opposed to the potentially, albeit guaranteedly lower, but fluctuating and potentially going up yields of common stockholders. The latter, of course, might go up if company performs outstandingly well, however, without a doubt can always drop easier as well, effectively leaving the common stockholders in a less secure, safer financial position compared to preferred shareholders.

Investment Flexibility

There are noteworthy differences in the opportunities and flexibility that both preferred stocks and common stocks offer. In terms of the level of flexibility that can be acquired by the investor, this could be a vital point in forming a stock portfolio strategy. The former will be more beneficial. The explanation for such a stance is that for many preferred stocks, a company includes an option to “call” that stock; thus, it can redeem the shares at a specified price after a specific period. As a result, the growth of these shares in the long run is capped; however, it is also predictable and guarantees a particular level of security to the investor at the market fluctuation time. For instance, Bank of America issues a preferred stock with a call feature effective in 5 years at $105 per share . In other words, the investment for this cardholder should be a stable 5% a year until it is called, as it is not known for sure that the company will not redeem these shares before it is due. It is typically seen when the market rates fell below the issued one; as a result, a company can refinance and repaint at a lower cost.

For common stocks, the situation is the opposite. In general, they are valuable as they offer an opportunity not limited by any call option – capital appreciation. Additionally, the flexibility and freedom to sell or buy at any time and keep both these dividends and this capital remain extremely beneficial. To prove this statement, one could mention the shareholders who bought Apple’s shares more than 20 years ago. If they did not sell their shares during these years, they should be extremely happy about their decision today as the Apple’s company is known to have grown explosively, their value has multiplied at least ten times in this period.

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