Preferred Stock vs Common Stock

Although we normally think of the stock of a specific company as a single security, public corporations often issue more than one type of stock. The two most common types are common stock and preferred stock. And while there's typically one class of common stock for a company, there may be several classes for preferred stock. Both are referred to as “stocks” and share certain characteristics, but they're actually two very different securities. Let's drill down into the comparison of preferred stock vs common stock.

What Is Common Stock?

Common stock is typically the most closely followed and widely issued stock of a company. In nearly every case where a company's stock is referenced, it refers to common stock. And unless an exchange-traded fund (ETF) or mutual fund specializes in holding preferred stock, it is the common stock of companies that are held in their portfolios.

For most companies, common stock is by far the largest amount of stock they issue. Common stock is typically the least restrictive form of stock ownership in any company.

When You Should Buy Common Stocks

The main advantage for investors in purchasing common stock is growth potential. Common stock tends to grow in price over time, much more quickly than either preferred stocks or bonds.

• Popular stock indexes like the S&P 500 index are composed of common stock, not preferred stock. When you buy into an index fund, you indirectly hold the common stock of hundreds or even thousands of publicly traded companies.
• Common stock also enables investors to buy shares in a larger number of companies, because more companies issue common stock than issue preferred stock.
• Virtually all publicly traded companies issue common stock. But only the larger and more well-established companies issue preferred stock.
• Because of the larger number of shares available, common stocks tend to be more liquid investments. Small-issuance preferred stock may be more difficult to sell due to more limited trading activity.

What Is Preferred Stock?

Much like common stock, preferred stock represents ownership in the issuing company. This distinguishes them from bonds, which are liens on the issuing company.

However, preferred stocks act as something of a hybrid between common stocks and bonds, even though they're legally classified as stocks. That's because the primary benefit of preferred stock vs. common stock is the payment of dividends. Investors in the common stock of a company rely primarily on long-term growth. But investors buy preferred stock for the dividends.

While common stock may pay dividends as well, preferred stocks almost always pay larger dividends, even within the same company.

Preferred stock dividends come with various formulas. For example, preferred stock may pay a fixed dividend amount. But they can also provide a variable dividend formula. A company may base preferred-stock dividends on a third-party index, such as the LIBOR (London Inter-bank Offered Rate). Each time there's a change in the index — either up or down — the dividend payment rate is adjusted accordingly.

When You Should Buy Preferred Stocks

The primary attraction of preferred stocks for investors is income. They buy preferred stocks when they find the dividend yield attractive. Not only will it be higher than the dividend yield on common stock in the same company, but it may even be higher than prevailing rates on other securities, such as bonds.

Preferred Stock Conversion Feature

There's another factor investors find attractive. Some preferred stock issues are convertible. That means you can exchange your preferred shares for a specific number of shares of the common stock in the same company. The preferred-stock holder gets the benefit of the higher dividend yield as well as an opportunity to take advantage of a significant rise in the price of the company's common stock.

For example, let's say you purchase preferred stock in a company when its common stock is trading at $80 a share. Then the price of the common stock rises $20. If the stock is convertible, you exercise your option to convert your preferred shares to common stock, thus gaining a $20 profit.

That gives you the benefit of the capital gain on the common stock while also having received the higher dividend yield before you exercised the conversion option.

But even if preferred stock is convertible there may be limitations.

Investor Beware: Preferred Stock May Be Callable

Preferred stock resembles bonds more than it resembles common stock in a few ways. One is callability. And this creates a potential trap for preferred-stock investors.

When preferred stock has a callability feature, the issuing company retains the right to redeem the shares after a certain amount of time. The potential hazard approaches when the dividend yield exceeds prevailing interest rates.

Companies issue preferred stock with dividend yields that are competitive with bond interest rates. But if bond rates fall after the preferred stock is issued, the company may exercise its right to call in the preferred stock. The company then issues a new preferred stock with a lower dividend yield.

This means that even if you buy a preferred stock with an attractive dividend yield, the issuing company may redeem the shares if bond yields fall below the dividend being paid on the preferred stock.

This may be the single biggest hazard of owning preferred stock.

Preferred Stock vs. Common Stock Comparison: Specific Features

So far, we've covered the basic differences between preferred stock vs. common stock. But there are even more differences with specific features, which we've broken down below.

Ownership of Company

Both preferred and common stock give the holder a share of ownership in the issuing company. Each can pay a dividend and can fluctuate in price — though fluctuations with preferred stock are much more limited.

Voting Rights

Here's where there's a fundamental difference between the two types of stock. Common stock holders qualify to vote on specific corporate policy and even to elect members of the board of directors.

Preferred shareholders have no voting rights. In this way, preferred stocks function more like bonds. The shareholder owns his or her preferred stock and receives the dividend yield, but he or she is not permitted to participate in voting on the activities of the company.

Price Each Security Is Based On

Common stock values are based primarily on market factors. Fundamentally, company earnings and profits drive prices. More specifically, market reactions to those numbers determine the share price.

Sometimes common stock prices also react to nonfinancial factors, such as the potential growth the market attaches to a specific line of the company's business. For example, the price of upstart healthcare stocks often rockets on the announcement of the development of a new drug, even though the company operates at a loss.

But the dividend yield determines preferred stock prices. Since preferred stocks produce little in the way of capital gains, investors buy them primarily for that yield. This makes them interest-rate sensitive.

To illustrate the point, let's say you purchase preferred stock in a company at $100 per share with a 4% dividend yield, giving you a $4 annual return. If interest rates on bonds rise 1%, the price of the preferred stock could fall to around $80. This increases the dividend yield to 5% even though the amount paid is still $4.

Conversely, if interest rates on bonds decrease by 1%, the value of the stock could rise to around $133. And that creates a 3% effective yield for the same $4 dividend.

This is virtually the same way long-term (20 years or longer) bonds react to changes in the interest rate. It's an inverse relationship. The value of the underlying security declines when rates rise. But when rates fall, the value of the underlying security rises.

Dividends

Preferred stock has a big advantage over common stock when it comes to dividends. Not only will preferred-stock holders be paid dividends before common- stock holders, but they're paid even if common-stock holders aren't.

That's where the “preferred” in preferred stock comes into play. Preferred stocks have a priority on the receipt of dividends. It's possible a company may cut or even eliminate the dividend on their common stock while preserving the full dividend on their preferred stock.

That doesn't mean preferred stocks are risk-free when it comes to dividends.

• A provision allows the company to suspend dividend payments on preferred stock based on the financial condition of the company. But preferred stock dividends are also cumulative.
• So the company must pay any suspended dividend payments when the company's financial situation improves. And the company pays those dividends to preferred-stock holders before any dividends are paid to common-stock holders.

Value if Held to Maturity

Common stock has no maturity date. They're open-ended shares of ownership in a company, with no expiration date.

Similar to a bond, though, preferred stocks often have a maturity date. This is typically 30 or 40 years after issuance. And the company redeems the shares for the original issuance amount after that timeframe has elapsed.

Preferred stock that is callable may also be redeemed for a specific price if the company decides to exercise the redemption.

Order Paid if Company Defaults

This is another example of where preferred stock behaves more like bonds than common stock. Upon the liquidation of the company, preferred-stock holders will be paid out of the assets before any payments are made to common-stock investors.

However, that doesn't mean preferred-stock holders are guaranteed a return of their original investment. Preferred stocks have priority over common stock in the liquidation, but they're behind other obligations, including bonds, taxes, payroll, and other company debts.

Why Companies Issue Preferred or Common Stock

Publicly listed companies issue common stock as a way to raise capital without using debt. They get the benefit of the sales proceeds from the initial sale of the stock. There is no requirement to pay interest or redeem the stock at a certain time in the future.

The company can also repurchase common stock shares when the value is low, then resell them at more favorable prices later. That gives the company the ability to raise capital without the fixed obligations that come with debt.

Companies issue preferred stock for similar purposes. While these carry an obligation to pay dividends, the company reserves the right to suspend those dividends based on financial circumstances. This capability doesn't exist when the company issues bonds, where the payment of interest is a contractual obligation.

That said, companies typically issue preferred stock only after exhausting their ability to issue either common stock or bonds.

That's because issuing preferred stock is more expensive than either of the other two funding methods. Compared to common stock, preferred stock requires payment of a higher dividend and on a more consistent basis. Compared to bonds, dividends paid on preferred stock are not tax-deductible, while interest on bonds is.

Bottom Line

Unlike common stock or bonds, which are virtually universal in investment portfolios, preferred stock represents a special class of investments.

• Preferred stocks appeal primarily to income-oriented investors. But they also have the potential for capital appreciation based on fluctuations in the stock price itself or the convertibility into common stock if that option is offered.
• But preferred stocks have certain risks investors need to be aware of. First and foremost is interest rate risk. If you buy a preferred stock with a certain dividend yield and interest rates rise, the value of the stock falls.
• The other issue is that preferred stock is callable. If interest rates fall, the issuing company will most likely exercise the call option. That denies you the opportunity to preserve the higher dividend yield in a lower interest rate market.
• For all these reasons, preferred-stock investing is far less common than investing in common stock. Preferred stocks can be profitable but you need to be aware of the risks before taking the plunge. And as is the case with common stock, you should diversify your preferred-stock holdings between several companies to minimize risk.

If you decide to buy a preferred stock, you do so the same way you buy common stock from your online broker. Simply type the preferred-stock symbol into the Buy section of your broker's website. If you don't know the symbol, your broker will likely have a search function to find it. Or type the name of the company into any internet search engine. And be sure to include the word “preferred” in your search query.