"Common Stock vs Preferred Stock: Understanding the Difference" is an essential guide for every investor seeking to broaden their knowledge of the diverse types of shares available in the market. A question often asked by new investors is: "What is common stock vs preferred stock, and which one should I invest in?"
This article looks into the intricate features of common stock vs preferred stock, providing a comprehensive comparison to help investors make informed decisions. Whether you're a novice investor or an experienced one looking to diversify your portfolio, understanding the key differences between common and preferred stock can provide valuable insights to optimise your investment strategy.
What are common stocks?
Common stocks are the most prevalent type of shares that investors purchase when they buy equity in a company. As a common shareholder, you essentially become a partial owner of the company, with the ownership proportion corresponding to the number of shares you hold. One key difference in the common stock vs preferred stock debate is the voting rights that come with common shares, allowing shareholders to participate in electing the company's board of directors and influencing corporate policies.
These stocks also entitle holders to dividends, a portion of the company's profits distributed among shareholders. However, these dividends are not guaranteed and depend on the company's financial performance. While the potential for high returns makes common stocks attractive, they also come with higher risk and are last in line for claims on assets in the event of company liquidation.
What are preference stocks?
Preferred stocks, often referred to as preference shares, offer a different set of benefits and risks to shareholders. These shares typically come with a fixed dividend, providing a steady income stream to investors. Crucially, preference shareholders have a higher claim on the company's earnings and assets compared to common shareholders. This means that in case of dividends distribution or company liquidation, preferred shareholders are paid before common shareholders. However, unlike common stocks, preferred stocks generally do not carry voting rights, meaning shareholders cannot influence the company's decisions or elect its board of directors. Different types of preferred stocks, such as cumulative, non-cumulative, redeemable, and convertible preference shares, offer additional variations in terms of benefits and conditions.
Types of Preference Shares
Preference shares, also known as preferred stocks, come in various forms, each offering a unique set of benefits to investors. The types of preference shares are generally distinguished by their dividend payment terms, redemption clauses, and conversion options. Here are the main types of preference shares:
● Cumulative Preference Shares: This type of preferred stock is named for its feature of cumulative dividends. If a company is unable to pay dividends in a particular year due to financial constraints, the unpaid dividends accumulate and are paid out in subsequent years when the company's financial health improves. Importantly, these accumulated dividends must be paid before any dividends are distributed to common shareholders.
● Non-Cumulative Preference Shares: Unlike cumulative preference shares, non-cumulative preferred stock does not allow for the accumulation of unpaid dividends. If the company doesn't declare dividends in a particular year, these shareholders cannot claim the unpaid dividends in the future.
● Redeemable Preference Shares: These shares carry a feature that allows the issuing company to buy back the shares from shareholders after a predetermined period. This redemption can happen either on a specific date or anytime at the company's discretion, providing the company with the flexibility to reduce shareholders' equity when needed.
● Irredeemable Preference Shares: Also known as perpetual preferred stock, these shares cannot be redeemed during the company's lifetime. The only circumstance in which these shares can be redeemed is if the company goes into liquidation or ceases to operate.
● Participating Preference Shares: Shareholders of participating preference shares enjoy a higher potential for returns. In addition to receiving a fixed dividend, they are also entitled to a share in the surplus profits of the company. Furthermore, in the event of liquidation, after repayment to all creditors and preference shareholders, the remaining assets are also shared with these shareholders.
● Non-Participating Preference Shares: These shareholders are only entitled to a fixed rate of dividends and do not share in the surplus profits or assets upon liquidation.
● Convertible Preference Shares: This variant grants shareholders the privilege to transform their preferred shares into common shares once a certain time period has elapsed. The feature can be attractive to investors as it allows them to benefit from the company's growth by converting their shares into common stock.
● Non-Convertible Preference Shares: As the name suggests, these shares cannot be converted into common stock.
● Preference Shares with a Callable Option: These shares can be repurchased or "called in" by the company at a predetermined price and date. This option provides the issuing company with the ability to reduce its outstanding shares when it is beneficial to do so.
Difference Between Common Stock vs Preferred Stock
To ensure a diversified investment portfolio, it is crucial to understand the differences between common stock and preferred stock.
Provides voting rights, allowing shareholders to participate in the company's decision-making process.
Usually does not offer voting rights.
Dividends are not guaranteed and may fluctuate based on the company's financial performance.
Shareholders are usually assured of a fixed dividend.
In case of liquidation, common shareholders are paid last, after creditors and preferred shareholders.
Preferred shareholders have a higher claim on assets and earnings. They get paid before common shareholders in the event of liquidation.
Common stocks have higher potential for capital appreciation.
Preferred stocks offer relatively stable returns and are less volatile.
Which one to buy between Common stock vs Preferred Stock?
Preferred stock vs common stock: which offers more benefits to the investor? This question requires a careful understanding of each type's characteristics.
● If you're seeking potentially high returns and willing to tolerate higher risk, common stocks may be the better choice.
● If you're interested in having a say in the company's decision-making process, common stocks provide voting rights.
● If you prefer a steady income and less risk, preferred stocks may be more suitable as they offer regular dividends.
● In the case of a company's liquidation, preferred stocks are safer as they have
a priority claim on the company's assets.
How to buy Common stock and Preferred stock
● Open a Demat Account: The first step is to open a Demat account with a registered broker or a financial institution. This is a type of account that holds shares in an electronic form.
● Complete KYC Process: Complete the KYC (Know Your Customer) process which involves providing personal identification documents.
● Research: Conduct thorough research about the company whose stocks you wish to buy. Look into the company's financial health, growth prospects, management, and market conditions.
● Choose between Common Stock vs Preferred Stock: Based on your investment goals, risk tolerance, and investment horizon, choose between common stock vs preferred stock.
● Place an Order: After deciding the type of stock and the number of shares to buy, place an order through your broker. You can place a market order (buy at the current price) or a limit order (buy at a specific price).
● Monitor Your Investment: After purchasing, regularly monitor your investment and make adjustments based on market conditions and changes in your financial goals.
In the world of finance, common stock and preferred stock are terms frequently used by investors and brokers alike. Both common stock vs preferred stock offer distinct advantages and cater to different investor needs. While common stock presents higher growth potential and voting rights, preferred stock offers more stable returns and priority in dividend payouts and liquidation. When it comes to common stock vs preferred stock, it's crucial to align your choice with your investment goals, risk tolerance, and financial needs.
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Frequently Asked Questions
Preferred stock is often cheaper than common stock due to the lower risk associated with it. Preferred stocks offer a fixed dividend and have a higher claim on assets in case of liquidation, making them less risky.
The risk of common stock lies in the volatile nature of stock prices and the potential for a company to not pay dividends. Also, in the event of liquidation, common shareholders are paid last.
The risk of the preferred stock lies in the fixed dividends. If the company does exceptionally well, preferred stockholders don't benefit from increased profits like common stockholders would. Also, preferred stocks can be called back by the company.
Preferred stock isn't refundable, but certain types, known as redeemable or callable preferred stock, can be bought back by the issuing company at a predetermined price.
Yes, preferred stock can be sold just like common stock. They are traded on the open market, and their price fluctuates based on market conditions and the performance of the issuing company.
Preferred stock is issued by corporations. This type of stock is a way for companies to raise capital without increasing debt or diluting the voting power of common stockholders.