Common Stocks vs Preferred Stocks

Introduction

When people hear the word stock, they often think of ordinary shares that can rise or fall in value on a stock exchange. These are generally known as common stocks.

However, companies can also issue another type of equity security called preferred stock. Although both represent an ownership interest in a company, they can provide very different rights and financial characteristics. The main differences involve voting rights, dividend payments, priority in liquidation, income potential, and price behavior.

Common stocks generally offer greater potential for capital appreciation and are often associated with voting rights. Preferred stocks, on the other hand, typically provide greater priority for dividends and claims on assets than common stock, although their potential for capital appreciation may be more limited.

Understanding common stocks vs preferred stocks is important because the two securities can serve different purposes in an investment portfolio. This guide explains how each type works, their major differences, advantages and disadvantages, and what beginners should know before investing.

What Is Common Stock?

Common stock represents an ownership interest in a company and is the type of stock most individual investors encounter. When you buy common shares of a publicly traded company, you become a common shareholder. Common shareholders may have several rights, depending on the company’s structure and the class of shares.

These can include:

• Voting rights
• Potential dividend payments
• Potential capital appreciation
• Participation in shareholder meetings
• A residual claim on company assets after higher-priority claims

Common stock prices can fluctuate significantly because they are influenced by company performance, investor expectations, economic conditions, market sentiment, and many other factors.

Example of Common Stock

Suppose you buy 100 common shares of a company at $20 per share.

Your initial investment is:

100 × $20 = $2,000

If the stock rises to $30, your shares are worth:

100 × $30 = $3,000

Your unrealized gain is $1,000.

However, if the stock falls to $15, your shares would be worth only $1,500.

This illustrates one of the key characteristics of common stock: greater exposure to changes in the company’s market value.

What Is Preferred Stock?

Preferred stock is another form of equity security that typically gives shareholders priority over common shareholders for dividends and claims on assets if the company is liquidated.

Preferred shares generally combine some characteristics associated with stocks and bonds.
Like common stock, preferred stock represents equity in a company. Like bonds or other income-oriented securities, preferred stock may provide a relatively predictable dividend according to its terms.

However, preferred stock is not the same as a bond. It remains an equity security and has its own risks and conditions. The exact features of preferred stock can vary considerably between companies and individual issues.

Common Stocks vs Preferred Stocks: Key Differences

The easiest way to understand the difference is to compare their main characteristics.

These are general characteristics. The actual rights of any stock depend on its specific terms and corporate structure.

Voting Rights

One of the biggest differences between common and preferred stock is voting power.

Common Stock Voting Rights

Common shareholders often have voting rights.

They may vote on matters such as:

• Electing directors
• Certain mergers
• Corporate reorganizations
• Other major corporate decisions

Typically, shareholders receive voting power based on the number and class of shares they own. An investor with a small number of shares in a large public company will generally have very limited practical influence, even though they may have voting rights.

Preferred Stock Voting Rights

Preferred shareholders often have limited or no ordinary voting rights. However, the specific terms can provide voting rights under certain circumstances.

For example, a preferred shareholder may receive voting rights if the company fails to pay dividends for a specified period or if certain corporate actions could materially affect preferred shareholders. The exact terms must be reviewed for each preferred stock issue.

Dividends: Common vs Preferred

Dividends are another major difference.

Common Stock Dividends

Common-stock dividends are generally discretionary.

A company may:

• Pay a dividend
• Increase a dividend
• Reduce a dividend
• Suspend a dividend
• Stop paying dividends

Even companies with a history of paying dividends can change their dividend policies. Common shareholders therefore cannot assume that a dividend will continue at the same level.

Preferred Stock Dividends

Preferred stock generally has a stated dividend rate or amount according to its terms.
For example, a preferred stock may have a dividend rate based on its stated value. If a preferred share has a $25 liquidation preference and a 6% dividend rate, its stated

annual dividend would be:

$25 × 6% = $1.50 per share

However, investors should understand whether the preferred dividend is cumulative or non-cumulative, among other features.

A cumulative preferred stock generally provides that unpaid dividends accumulate, subject to the security’s terms. With non-cumulative preferred stock, missed dividends generally do not accumulate in the same way.

Liquidation Preference

Liquidation priority is another important difference. If a company experiences severe financial problems and is liquidated, different groups have different claims on the company’s remaining assets.

A simplified priority structure is often:

Creditors → Preferred shareholders → Common shareholders

This means preferred shareholders generally have a higher claim on company assets than common shareholders. However, preferred shareholders still rank behind creditors and other higher-priority claims.

Common shareholders are generally last among these groups. This priority can make preferred stock less risky than common stock in some respects, but it does not eliminate the possibility of losing money.

Capital Appreciation Potential

Common stock generally has greater potential for capital appreciation. If a company’s business grows rapidly, its common stock price may increase substantially as investors revise their expectations about future earnings and cash flows.

Preferred stock can also increase in value, but its price is often more closely connected to its dividend characteristics, interest rates, credit quality, and redemption or conversion terms. Therefore, investors primarily seeking long-term growth often look more closely at common stocks, while investors seeking income may consider preferred stocks.

Common Stock vs Preferred Stock: An Example

Imagine a company has both common and preferred shares.

You purchase:

100 common shares at $20 = $2,000

Another investor purchases:

100 preferred shares at $25 = $2,500

Suppose the company performs exceptionally well and its common stock rises from $20 to $35.

The common shares would now be worth:

100 × $35 = $3,500

The investor has an unrealized gain of $1,500.

The preferred shares may behave differently. Their value may be influenced more heavily by their dividend, interest-rate conditions,credit quality, and other terms.This demonstrates why common and preferred shares can respond differently even though both represent ownership in the same company.

Advantages of Common Stocks

1. Higher Growth Potential

Common stocks can benefit significantly from business growth. If a company expands its revenue and profits over many years, shareholders may benefit through higher stock prices.

2. Voting Rights

Many common shares provide voting rights, allowing shareholders to participate in certain corporate decisions.

3. Dividend Potential

Some common stocks provide regular dividends. Companies may also increase dividends over time, although dividend payments are never guaranteed.

4. Broad Availability

Common shares are widely available across stock exchanges and investment platforms.

5. Long-Term Wealth-Building Potential

Common stocks can play an important role in long-term portfolios because of their potential for capital appreciation and dividends.

Disadvantages of Common Stocks

1. Greater Price Volatility

Common stock prices can fluctuate substantially.

2. Lower Priority

Common shareholders generally have a lower claim on company assets than creditors and preferred shareholders.

3. Dividends Are Not Guaranteed

Companies can reduce or eliminate common-stock dividends.

4.Business Risk

Poor company performance can negatively affect both the share price and the investor’s portfolio.

Advantages of Preferred Stocks

1. Dividend Priority

Preferred shareholders generally have priority over common shareholders when dividends are declared, subject to the terms of the preferred issue.

2. Higher Liquidation Priority

Preferred shareholders generally have a higher claim on company assets than common shareholders during liquidation.

3. Potentially More Predictable Income

Many preferred stocks have specified dividend terms, which can make their income characteristics more predictable than common stocks.

4. Potentially Lower Volatility

Some preferred stocks may experience less price volatility than common shares, although this is not guaranteed.

5. Hybrid Characteristics

Preferred stock can offer a combination of equity ownership and income-oriented features.

Disadvantages of Preferred Stocks

1. Limited Voting Rights

Preferred shareholders often have fewer voting rights than common shareholders.

2. Lower Growth Potential

Preferred stock may have less potential for substantial capital appreciation than common stock.

3. Interest-Rate Risk

Preferred stocks can be sensitive to changes in interest rates. When market interest rates rise, existing preferred securities with fixed dividend rates may become less attractive relative to newly issued securities with higher yields.

4.Call Risk

Some preferred stocks are callable, meaning the issuing company may have the right to redeem them under specified conditions. This can limit potential gains for investors.

5. Dividend Risk

Preferred dividends are generally not equivalent to guaranteed interest payments on a bond. The terms vary, and investors can still face financial losses.

Are Preferred Stocks Safer Than Common Stocks?

Preferred stocks can have certain advantages over common stocks, particularly regarding dividend and liquidation priority. However, it would be inaccurate to describe all preferred stocks as safe.

Preferred stocks can lose market value because of:

• Rising interest rates
• Declining company credit quality
• Changes in market conditions
• Company-specific problems
• Reduced investor demand
• Changes in dividend expectations

Preferred shareholders also remain behind creditors in the capital structure. Therefore, preferred stock should be understood as a different type of risk rather than a risk-free alternative to common stock.

Common Stocks vs Preferred Stocks During Bankruptcy

If a company enters bankruptcy or liquidation, investors need to understand the capital structure. Creditors generally have priority over equity holders. Preferred shareholders generally rank ahead of common shareholders. Common shareholders are generally last.

For example, suppose a company has $50 million in assets but $70 million in obligations and claims ahead of common shareholders. There may be nothing left for common shareholders after higher-priority claims are satisfied. Preferred shareholders may also receive nothing if the company’s assets are insufficient to satisfy their claim. This is why both types of stock can carry substantial risk.

Convertible Preferred Stock

Some preferred shares are convertible. Convertible preferred stock may give investors the ability to convert preferred shares into common shares under specified terms.

This can allow investors to participate in potential growth in the company’s common stock while initially holding a security with preferred characteristics.

However, conversion terms vary, so investors need to understand:

• Conversion ratio
• Conversion price
• Conversion dates or conditions
• Dividend terms
• Redemption provisions

Convertible preferred stock can therefore be more complex than ordinary common shares.

Participating and Non-Participating Preferred Stock

Preferred stock can also have different participation characteristics.

Non-Participating Preferred Stock

A non-participating preferred shareholder generally receives the specified preferred benefit but does not additionally participate in the remaining common equity value beyond the applicable terms.

Participating Preferred Stock

Participating preferred stock may allow the shareholder to receive the preferred return and potentially participate further in distributions, depending on the terms. These structures are particularly important in certain private-company financing arrangements.

Who Typically Considers Common Stocks?

Common stocks may be attractive to investors who prioritize:

• Long-term growth
• Capital appreciation
• Voting rights
• Dividend growth potential
• Broad equity-market exposure

For example, an investor building a long-term portfolio may use common stocks because they provide direct exposure to the growth of businesses. However, individual stocks can carry significant company-specific risk.

Who Might Consider Preferred Stocks?

Preferred stocks may appeal to investors who prioritize:

• Income
• Dividend priority
• Greater claim on assets than common shareholders
• Potentially lower volatility than common stock
• Specific preferred-stock features

They can be useful in certain income-oriented strategies, but investors should carefully evaluate the issuer’s financial condition and the security’s terms.

Common Stocks vs Preferred Stocks: Which Is Better?

There is no universal answer.

The better choice depends on the investor’s objectives.

Investors should evaluate each security individually rather than assuming one type is always better.

Common Stock vs Preferred Stock vs Bonds

Preferred stock is sometimes described as being between common stock and bonds, but the comparison needs to be understood carefully.

Common stock: Generally offers the greatest potential for equity growth but also carries significant risk.

Preferred stock: Generally provides priority over common stock for dividends and liquidation, while retaining equity characteristics.

Bonds: Represent debt rather than ownership and generally have contractual interest and repayment terms, subject to the issuer’s ability to pay.

The capital structure can be simplified as:

Debt → Preferred Equity → Common Equity

The exact legal and economic ranking can vary depending on the securities involved.

Common Mistakes Beginners Make

Assuming Preferred Stock Is Guaranteed

Preferred dividends are not automatically equivalent to guaranteed bond interest.

Looking Only at Dividend Yield

A high yield can sometimes reflect higher risk. Investors should examine the issuer’s financial health and the terms of the preferred security.

Ignoring Interest Rates

Preferred stocks can be sensitive to interest-rate movements.

Assuming Common Stock Always Has Higher Returns

Common stock may have greater growth potential, but actual returns depend on the company and purchase price.

Ignoring Share Class Terms

Two preferred stocks can have very different features. Always examine the security’s specific terms.

Frequently Asked Questions

1. What is the main difference between common and preferred stock?

The main differences involve voting rights, dividend priority, liquidation priority, and potential for capital appreciation. Common stock generally offers more voting rights and growth potential, while preferred stock generally offers greater priority for dividends and assets.

2. Is preferred stock safer than common stock?

Preferred stock can have higher priority than common stock, but it is not risk-free. Its value can decline, and investors can still lose money.

3. Do preferred shareholders have voting rights?

Preferred shareholders often have limited or no ordinary voting rights, although the specific terms may provide voting rights under certain circumstances.

4. Which stock is better for long-term growth?

Common stock generally has greater potential for long-term capital appreciation, but the appropriate investment depends on the investor’s goals, risk tolerance, and portfolio.

5. Which stock is better for dividends?

Preferred stocks often have more defined dividend terms and priority over common stock, but investors should review the specific security before investing.

6. Can preferred stock lose value?

Yes. Preferred stock prices can fall because of interest-rate changes, company-specific problems, market conditions, and other factors.

7. Can preferred stock be converted into common stock?

Some preferred stocks are convertible. The conversion terms depend on the specific security.

8. Do common stocks always pay dividends?

No. Companies can choose not to pay dividends and may instead reinvest available capital into the business.

Conclusion

Understanding common stocks vs preferred stocks is essential for anyone learning how equity investments work.

Both securities represent an ownership interest in a company, but their characteristics can be very different. Common stock generally provides greater potential for capital appreciation and often comes with voting rights. Preferred stock generally receives priority over common stock for dividends and liquidation claims, but it often provides fewer voting rights and may have more limited growth potential. Neither type is automatically better.

Investors should consider their objectives, risk tolerance, income requirements, time horizon, and the specific terms of the security before investing. They should also remember that preferred stock is not the same as a guaranteed-income investment, and common stock can experience significant price volatility.

The key is to understand what you are buying and why it fits your investment strategy. A strong foundation in concepts such as shares, dividends, equity, valuation, and risk can help investors make more informed decisions.

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