As an investor, you may be wondering whether it’s better to purchase shares of common or preferred stock in a corporation. Since common stock is more frequently traded than preferred, it’s important to understand some of the differences between the two classes of stock. There are certain characteristics that are unique to preferred shares, but determining whether they are beneficial depends on your individual investment goals.
Dividend Payment Priority
The most attractive feature of preferred stock is the preference shareholders have to corporate dividends. Preferred shares pay annual dividends that are a fixed percentage of the stock’s par value or purchase price. This requires the corporation to pay dividends to all of its preferred shareholders before any dividends can be paid to its common shareholders -- but only if the corporation decides to declare a dividend at all. For example, if you purchase a preferred share with a par value of $100 and an annual dividend of 10 percent, this means that if the corporation declares a dividend during the year, it must provide you with a $10 payment for each share you own before it can make dividend payments to common shareholders. However, if the corporation doesn’t earn a profit, there is no requirement that it pay dividends to any shareholders.
Cumulative Dividend Payments
When investing in preferred stock, you should always consider whether the shares are cumulative or noncumulative. Preferred shares are cumulative if the corporation increases your dividend payment to include the dividends it fails to declare in prior years. For example, if the corporation doesn’t provide you with the $10 dividend in one year, it means that by the next year it must pay a $20 dividend for each preferred share you own before providing common shareholders with a dividend payment. Noncumulative isn’t a desirable feature because in this scenario, the corporation doesn’t owe you any dividend payments for the years it decides not to declare a dividend.
In addition to priority when it comes to the payment of dividends, preferred shareholders also have a superior claim to a corporation’s assets when it goes out of business and liquidates its assets. When a company decides to liquidate and cease its operations, it must pay all of its debts to creditors before any distributions are made to shareholders. If there are assets left after all creditors receive full payment, preferred shareholders must receive their investments back -- which is equal to the stock’s par value -- before any common shareholder receives a return of their capital.
Preferred Stock Disadvantages
Common shareholders generally seek returns on their investments through appreciation in a stock’s value rather than through the periodic dividend payments that preferred shareholders receive. For example, if a company quadruples its earnings one year because of a new innovative product it begins manufacturing; common shareholders can earn a significant amount of money if the market price of the stock increases. However, preferred shareholders generally don’t have the same upside potential that common shareholders enjoy, because the preferred share prices are less volatile.