Differences Between Common Stock and Preferred Stock
When a business needs more money to invest into their growing business, they can opt for issuing shares. Issuing shares can be of two types – common shares and preferred shares.
When we talk about stocks, it actually means common stock. Through common stocks, shareholders can earn dividend and can also sell out their stocks when the selling price goes above and beyond their purchase price. Common shareholders are also given voting rights in corporate challenges or decision-making processes.
As the name suggests, preference shareholders are given preference over common shareholders. Though preference shareholders are not given any voting rights, they are opted first for the dividend pay-out before common shareholders.
In this article, we will look at the differences between common stock vs preferred stock and would see the similarities and differences.
Let’s get started.
- Common Stock vs Preferred Stock Infographics
- What are Common Stocks?
- What are Preferred Stocks?
- Common Stock vs Preferred Stock – Key differences
- Common Stock vs Preferred Stock (Comparison Table)
Common Stock vs Preferred Stock Infographics
There are many differences between common stocks vs preferred stocks. Let’s have a look at them one by one –
What are Common Stocks?
Common stocks are ordinary stocks issued to public to generate a stream of funding to expand the business.
A private company needs to become public to be able to issue common stocks.
That’s why they need to conduct initial public offering (IPO) to go public and become registered in a valid stock exchange.
Let’s go deep into common stock.
Initial Public Offering (IPO)
We will take an example to illustrate IPO Process.
The IPO process is way-out to sell the first share of the company to the public.
Steve has a business in his downtown. He sells old classic books. His clientele is huge and he serves a lot of people in this area.
Steve is advised by his friends that he should go big. He should open stores of his old classic books so that he can reach out to a greater audience.
The idea seems great for Steve. But he doesn’t have enough cash to open stores in different cities. So he goes to an investment bank and asks for help.
The investment bank suggests Steve that he should go for IPO. Steve says that’s a great idea. So he asks the bank for help.
The investment bank comes to Steve’s bookstore and does a valuation of his business. They find that the value of the bookstore is more than $500,000. So they advise Steve to go for 50,000 shares with $10 each share.
Steve decides that he would keep 50% of his shares and would sell out the remaining 50%. He sells out 25,000 shares at the rate $10 each and accumulates around $250,000.
He has now decided to use this money to open new stores in 3 new cities.
This is how IPO process works. And it’s best for those companies which don’t want to go for long term loans.
Rights of common stockholders
Common stocks are equated with owner’s funds.
If you’re one of the common shareholders of the company, you are the owner of the company.
And the whole theory of business revolves around common stockholders. The whole business works to maximize the wealth of the shareholders.
So, common stockholders have an important role to play in helping a company perpetuate.
Here are the rights of the common stockholders –
- Voting rights: The common stockholders can offer their important votes on issues the business has been facing or struggling with. This is an important right because preferred shareholders are not given the right to vote even after receiving the dividend before common stockholders.
- Right to receive dividends: Common stockholders have the right to receive dividends if the company makes profits. When a company just gets started, usually they don’t pay off the dividend to the shareholders and the entire money is reinvested into the business. This is done after taking permission from the board of directors. Later when the core of the company gets strengthened, then they pay off a certain percentage to the common stockholders as dividends. But that’s done after repaying any loans company has and after paying off the dividend to preferred stockholders.
- Right to sell off the stocks for profits: The common stockholders who are also called equity shareholders can sell off their stocks to someone else at a higher price. Since there’s no way common stocks can be redeemed, equity shareholders can sell of their stocks to someone interested to own the stocks of that particular company at a higher price. This right allows the common stockholder make huge profits and become wealth pretty quickly.
- Right to receive the remaining cash after liquidation: If a business decides to liquidate, equity shareholders have the right to receive cash depending on their ownership of shares. But the only issue is after liquidation, first, all the liabilities have to be paid off. Then the preferred shareholders are paid. And then if any amount remains untouched, that amount is distributed to the common stockholders on the basis of the proportion of ownership.
As you can see owning a common stock has a lot of benefits. But you need to know which common stock to go for.
The best approach is to go for a portfolio of common stocks to mitigate the risks and to earn a decent income from common stocks.
Shareholders’ equity statement
To record the common stock and also preferred stock (if any), a financial statement is maintained by the company.
This shareholders’ equity statement is one of four most important financial statements every investor should look at.
Let’s have a look at the format of the shareholders’ equity statement.
|Additional Paid-up Capital:|
|(-) Treasury Shares||(**)|
|(-) Translation Reserve||(**)|
What are Preferred Stocks?
Preferred stocks are the extension of common stocks but preferred stockholders are given preference in dividend pay-out.
For example, if a company issues preferred shares, the dividend payout remains fixed. The rate is usually higher than the dividend payout ratio of common stockholders.
However, if the company does well, the dividend pay-out of the common stockholders will increase and the dividend pay-out of the preference stockholders won’t since it is fixed.
In simple terms, preferred stock is the hybrid version of common stock and a bond. Because –
- When someone owns preference shares, he is entitled to receive dividends just like common stockholders. But the only difference is preference shareholders will be given preference in offering dividends.
- If someone own preference shares, she is also entitled to receive a fixed rate of dividend pay-out. That means if the company incurs loss, it has to pay dividend to the preference shareholders. And if the company makes profit, it has to pay dividend to the preference shareholders. And this is one of the most important characteristics of a bond.
Rights of preferred stockholders
Like common stockholders, preferred stockholders also have some rights. Let’s have a look –
- Right to own the company: Like common stockholders, preferred stockholders also have the right to own the company by purchasing the preferred stocks through brokers.
- Right to get a preferred treatment for dividend pay-out: The most significant advantage of preferred stockholders is to get the dividend even before the common stockholders. Even when the company doesn’t make any profit, preferred stockholders are entitled to receive dividend.
- Right to get a fixed dividend: When the preference shares are issued, preferred stockholders get a fixed rate of dividend. Currently, it is within the range of 5% to 7%. Individuals which are not very adventurous and are literally risk averse choose preferred stockholders since they get a fixed 5%-7% pay-out even when the company makes losses. Similarly it has a disadvantage too. Since the dividend pay-out rate is fixed, the preferred stockholders don’t get more dividends if the company makes huge profits. In this case, holding common shares seems to be more beneficial.
- Right to get preferred treatment after liquidation: Even when the business liquidates, the preferred stockholders are given preference in paying out the dividend first. However, they’re not paid first since the company needs to pay off the liabilities first. But they get paid off before common stockholders. It may so happen that common stockholders would receive nothing since the money after liquidation gets exhausted after paying off the liabilities and the dividends of preferred stockholders.
- Right to receive arrears later: If a company doesn’t pay its preference shareholders in a year due to a particular reason, it has to pay them the arrears the next year. This is a special right and it is only enjoyed by preferred stockholders. Common stockholders don’t enjoy this right. If common stockholders are not paid in a year, the arrears aren’t paid the next year to the common stockholders.
Which stocks should you choose between Common Stock vs Preferred Stock?
The answers would be different for different sets of people.
If you’re someone who likes to take a risk and loves to see your money getting doubled, tripled, quadrupled, then maybe you should go for common stocks.
Owning common stocks will enable you with a lot of growth potential but you won’t enjoy a fixed dividend. But you will grow with the company.
On the other hand, if you’re someone who doesn’t want to take much risk and wants to enjoy a decent dividend pay-out, you should go for preferred stocks.
The idea is to see how tolerant and patient you’re in your investment journey. If you can take more risk, common stocks would be the best bet. But if you’re someone with risk-averse attitude, you should definitely buy preferred stocks from brokers.
So, there’s no right or wrong answer to this. You’re the best judge of what you should purchase and why.
Common Stock vs Preferred Stock – Key differences
The key differences between common stocks vs preferred stocks are as follows –
- The main difference between common stocks vs preferred stocks is that common stockholders don’t receive the dividend until the preferred stockholders receive it.
- Common stockholders don’t receive the dividend as per a pre-determined rate. Preferred stockholders receive the dividend as per a pre-determined rate.
- Common stockholders grow with the company. That means the growth potential of common stockholders is huge. The growth potential of the common stockholders, on the other hand, is fixed.
- Common stockholders have voting rights and they can vote on the important issues of the company. Preference stockholders don’t have any voting rights.
- After liquidation, the common stockholders are paid last. After liquidation, the preferred stockholders are paid before the common stockholders.
- If the common stockholders aren’t paid in a year, the arrears don’t accrue in the next year. In the case of preferred shareholders, the arrears accrue and the company has to pay the arrears to the preferred stockholder in the next year.
- If the company makes profits, common stockholders receive dividends. If a company incurs losses, common stockholders don’t receive any dividend. But in the case of preferred stockholders, they receive money whether the company makes profits or incurs losses.
Common Stock vs Preferred Stock (Comparison Table)
|Basis for Comparison – Common Stock vs Preferred stock||Common Stock||Preferred Stock|
|1. Inherent meaning||Ordinary shares with voting rights and right to receive dividends.||Preferred shares without voting rights but condition to receive preferential dividends.|
|2. Voting rights||Common stockholders have voting rights on various issues of business.||Preferred stockholders don’t have any voting right.|
|3. Dividend distribution||Common stockholders don’t always receive dividends.||Preferred stockholders always receive dividends at a fixed rate.|
|4. Priority – common stock vs preferred stock||Common stockholders are not given priorities since they are considered as owners of the company.||Preferred stockholders are paid after the debt-holders but before the common stockholders.|
|5. Transferring right in Common vs Preferred Stocks||Not given.||Given.|
|6. Sharing of profits/loss in Common vs Preferred Stocks||If there’s no profit, common stockholders receive nothing.||Irrespective of making profits/incurring losses, preferred stockholders receive the dividend.|
|7. What’s about arrear?||Don’t receive arrears in the next year.||Receive arrears in the next year.|
|8. Possibility of growth||Very high.||Pretty low.|
Conclusion – Common Stock vs Preferred Stock
If your idea is to make more money and you want to see the good and bad of both common stocks and preferred stocks, a better approach is to mix and mingle the two.
You can buy common stocks of a growing company and buy preferred stocks of a mature company.
Doing this will help you get the benefits of both and mitigate one with another.
If you don’t make enough money on common stocks, your dividends on preferred stocks are already ensured. And if you also make money on common stocks, you will quickly become wealthy.
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