Common vs. Preferred Stock: What to Know Before Buying

One method corporations use to fund their expansion or growth is to issue shares of stock—also known as “equity financing.” By issuing stock, the company receives capital, and, in exchange, you (the shareholder) become an owner of the business.

More specifically, companies issue two types of stocks: common and preferred. While each represents company ownership, be sure to familiarize yourself with key differences before purchasing one or the other.

An overview of common stock

When you own at least one share of company stock, you become an official company shareholder—providing you with voting rights on corporate policies and the ability to elect the organization’s board of directors.

A share of common stock also generally performs better than other types of ownership equity over the long-term and can thus generate significant returns for investors (making this an attractive investment). However, common stock is also sometimes the riskiest option since, in the event of bankruptcy, shareholders have a right to company assets only after bondholders, preferred stockholders, and other debtholders are paid in full.

An overview of preferred stock

Preferred stocks are more of a hybrid type of investment, as they boast features of both common stock and bonds. Like common stock, they are purchased in the same way and pay out dividends. Yet, preferred stocks behave similarly to bonds in that dividends are agreed upon and paid at regular intervals, and the market value of preferred stocks is also sensitive to interest rate changes.

An advantage of preferred stocks is that they pay a higher dividend rate than common stock issued by the same company. Moreover, the issuing company must pay out preferred stock dividends before doing the same for any common share dividends. Preferred stockholders also rank higher than common stockholders in the event of liquidation. These benefits are often the reasons why preferred stocks are generally considered less risky than common stocks.

However, unlike common stock shareholders, preferred stock shareholders usually don’t have voting rights.

Types of preferred stock

Preferred stock comes in various shapes and sizes. For the sake of brevity, let’s discuss some of the most common options:

With callable stocks, the issuing company has the right to buy back the stock at a fixed price after a predetermined date (often after a few years). Callable stocks pay a higher dividend to shareholders since they take on the added risk of potentially losing out on profits. From an issuer perspective, callable stocks give the company added protection from fluctuating interest rates. For example, if interest rates drop and the company can issue new callable preferred shares at a lower rate, said company can redeem outstanding shares and reduce capital costs. Conversely, if interest rates rise, shares likely won’t be redeemed and the issuer will continue paying the lower rate.

Convertible preferred stocks give investors additional protection by allowing them to convert preferred shares into a predetermined number of common shares at some point in the future. Convertible stocks are often associated with early-stage companies undergoing a rapid expansion.

A conversion can happen in several ways. For example, you may have the right to exercise this option whenever you want (the most common option). Alternatively, the stock may contain a provision dictating an automatic conversion at a predetermined date or allowing the company’s board of directors to vote for a conversion. The stock’s prospectus (a document revealing investment details) will lay out conversion specifics.

Cumulative preferred stocks allow companies to suspend dividends when they can’t afford to pay them. However, this type of stock protects investors in that unpaid dividends must be repaid before any dividends are paid to common shareholders. For example, if a company guarantees dividends of $1 per share and can’t afford to pay this for two consecutive years, it must pay a $3 cumulative dividend in the third year before any other dividends are paid.

Participatory preferred shares provide shareholders with an additional guarantee. Should the company meet specific financial goals (e.g., a revenue or profit target), shareholders will receive dividend payments above the normal fixed rate. This type of investment is best suited for investors who believe the company is well-suited for unusually strong earnings or primed to be sold for a high price.

Adjustable-rate preferred stocks (ARPS) pay out a dividend rate that is tied to a common benchmark: often the U.S. Treasury bill. As a result, your dividend is modified—typically on a quarterly basis. Because of this flexibility, adjustable-rate stock prices are more stable than fixed-rate preferred stocks and protect the company, as this type of stock features caps that prevent the issuer from needing to pay inordinately large dividends. ARPS are best suited for conservative investors, as their stability is a top selling point.

Terms and other details you should know about preferred stock

Like common stocks, you can invest in individual company preferred stocks, preferred stock mutual funds, or preferred stock exchange-traded funds (ETFs).

You should familiarize yourself with a few key terms before investing in preferred stock.

Dividends—company payments to shareholders—are based on earnings and issued in the form of cash, stock, and special dividends (which occur on an infrequent basis). As a result, these are typically paid out by more well-established companies that don’t need to reinvest their money.

The par value is the stock price stated in the company charter. The issuing company pays dividends based on a percentage of the par value, usually at a fixed rate. Thus, if the par value of the stock is $25 and the dividend is 3%, the issuer must pay $0.75 per year for as long as the preferred stock is outstanding.

Current yield represents the expected annual return an investor would enjoy by purchasing the stock. To compute the current yield, one must know the annualized dividend and divide that by the market price of the stock. Therefore, if the current market rate is $25 and the annualized dividend is $0.75, the current yield would be 3%.

Preferred stock benefits

The biggest selling point for preferred stocks is that they can offer steady income through interest or dividend payments. They also boast higher yields than other traditional fixed-income investments, such as bonds. Additional reasons to purchase preferred stocks? They are less risky than common stocks and enjoy a higher level of price transparency than bonds because they’re traded on the stock exchange. Due to these benefits, preferred stocks often provide an excellent way to diversify your portfolio.

Common vs. preferred stock: which should you choose?

If you’re looking for an investment with upside price potential and can stomach the likelihood of higher share price volatility, common stocks are perhaps best-suited for you. Alternatively, if you are more risk-averse and looking to maximize dividend income, investing in preferred stock is a great way to go.

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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.

Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business. 

There is no assurance that the techniques and strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal. Preferred stock dividends are paid at the discretion of the issuing company. Preferred stocks are subject to interest rate and credit risk. As interest rates rise, the price of the preferred falls (and vice versa). They may be subject to a call feature with changing interest rates or credit ratings. Dividend payments are not guaranteed and may be reduced or eliminated at any time by the company.