Common Stock Versus Preferred Stock

by Cam Merritt

Corporations raise capital by selling shares of stock, which represent shares of ownership in the company. "Common stock" is a company's regular stock; it comes with voting rights and the potential to receive dividends. Preferred stock is a special class that gives its holders priority for dividends and certain other benefits. Whether preferred shares are indeed preferable, though, depends on what you're looking for from a stock investment.

Priority Dividends

The most significant difference between preferred and common shares -- to most, the defining difference between them -- is that preferred shareholders are guaranteed to receive dividends, while common shareholders are not. Dividends are cash distributions of company earnings. It's typically up to the board of directors to decide whether to distribute a dividend to common shareholders and, if so, how much to pay per share. The amount and frequency of preferred dividends, on the other hand, are defined in advance. If the company doesn't have sufficient cash to pay them, the board might be able to suspend preferred dividends, but the company remains on the hook for those unpaid dividends and must pay them before dividend payments can resume to common shareholders.

Claim on Assets

When a company goes into liquidation -- disposes of its assets and goes out of business -- preferred shareholders have a higher-priority claim on the proceeds of the liquidation than common shareholders do. Stockholders are typically the last people to get anything back in a liquidation. This is the flip side of the limited liability that comes with stock ownership: If the company fails, your losses are limited to the amount you've invested in the company -- but at the same time, there's no guarantee that you'll get anything back, ever. First in line to get paid with the proceeds of a liquidation are the company's secured creditors, followed by its unsecured creditors. If there's any money left after paying back all the creditors, it goes to the shareholders. Preferred stockholders get their money back first, followed by common stockholders. (There usually isn't anything left over after paying the creditors, though; companies go into liquidation because their debts exceed the value of their assets.)

Voting Rights

Common stock is a company's voting stock. One share of common stock typically entitles you to one vote on matters such as the makeup of the board of directors and any corporate governance policies that the directors submit for shareholder approval. It's through this voting power that a shareholder can influence the company. Anyone who controls a majority of common shares -- by buying them up or by making alliances with other shareholders -- can control the company. Preferred stock, on the other hand, typically has no voting rights. Since a preferred share is an equity security, preferred shareholders are technically owners of the company, but they have no real say in how the company is run.

Price Volatility

Both common and preferred shares trade on the open market, but their prices are subject to different influences. Because the preferred dividend is defined in advance and doesn't change, preferred shares are similar to bonds. Their prices are largely determined by interest rates; prices rise or fall so that the fixed dividend represents a return comparable to current interest rates. This effectively places upper and lower limits on the price. Common stock price is far more volatile. All profits beyond those distributed as preferred dividends theoretically "belong" to the common shareholders, so the price of common stock rises and falls with the fortunes and perceived value of the company. There's no limit to how high the price can go -- but it can fall to zero, too.

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