Preferred stock vs. common stock: What’s the difference?
Editorial staff, J.P. Morgan Wealth Management
- Common stock and preferred stock are the two types of stock most often issued by publicly traded companies, and they each come with their own pros and cons.
- While holders of common stock may or may not get a dividend, preferred shareholders are generally entitled to regular dividend payments, which are often higher than and typically paid prior to common stock dividends.
- Compared to preferred stock, common stock’s upside potential tends to come more from growth in share price over time rather than dividends.
Purchasing shares of stock on the open market is a relatively easy way to invest in publicly traded companies and potentially profit from their growth. Owning stock gives investors a fractional ownership stake in a corporation. Corporations often use the money from the sale of stock to invest in headcount growth, pay off debt or ramp up their research and development, among other things.
As you invest in the stock market, it’s important to understand that there’s more than just one type of stock. While investors may more customarily buy and sell what is known as common stock, corporations may also issue something called preferred stock.
Understanding the difference between common and preferred stock may help you better decide and manage your investments. Keep reading as we cover the differences between these two investments below.
What is common stock?
Common stock is a type of security that represents a unit of ownership in a corporation, and it’s the one investors generally buy most often. Owning common stock generally gives shareholders voting rights, which means they typically have a say in important company decisions – like electing the board of directors and other management directives.
Each share is usually equal to one vote. Common shareholders may also receive dividend payments, depending on how profitable the company is.
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What is preferred stock?
Jacob Manoukian, J.P. Morgan Private Bank and Wealth Management’s U.S. Head of Investment Strategy, describes preferred stock as “securities that have some bond-like characteristics (they pay a consistent cash-flow stream to the holder), and some equity-like characteristics (subordination to other forms of debt but the potential for capital appreciation). The most common type of preferred equity is issued by banks, who use the capital to meet regulatory requirements, but companies in other industries can be issuers as well. Importantly, the income that preferred equities pay U.S. investors is typically taxed at qualified dividend rates, which are less onerous than ordinary income rates.”
Preferred stock typically offers a higher priority claim in the capital structure for assets and earnings than common stock, often including offering fixed dividend payments. Preferred stockholders usually don’t have voting rights, but they are generally entitled to receive dividend payments before common stockholders.
Why would an investor buy preferred stock?
One main benefit of preferred stock is being first in line when it comes to dividends. Preferred stockholders are the first to receive dividends, which aren’t always guaranteed to most investors holding common stock. These dividends are generally distributed on a regular basis, much like coupon payments received by bond investors.
Like bonds, most preferred stock comes with a par value, which is the value it’s issued at and can usually be redeemed at, when the shares mature. Also like bonds, preferred shares tend to be affected by interest rates. When interest rates go up, there is a risk that the value of preferred shares decline, and when interest rates decline, the value of preferred shares may increase.
Being a preferred stockholder has advantages if a company faces bankruptcy and its assets are liquidated. In this case, preferred stockholders take priority over common stockholders when it comes to recouping their investment, although they remain lower on the payout chain than those who hold the company’s senior debt.
What are some types of preferred stock?
Preferred stock can take different forms, including:
- Convertible preferred stock: The shares can be converted to a predetermined number of common shares.
- Cumulative preferred stock: If an issuer misses a dividend payment, the payment must be added to the next dividend payment. The issuer can’t pay common stockholders dividend payments until missed dividend payments are made to cumulative preferred stockholders.
- Participating preferred stock: Holders may receive extra dividend distributions should company earnings exceed expectations or if dividend payments to common stockholders exceed an arbitrary threshold.
- Callable preferred stock: These shares allow the issuing company to repurchase them at its discretion. Should the shares be called, the holder must sell them back to the issuing company. These shares typically pay a higher dividend due to call risk.
- Adjustable-rate preferred stock: Holders of adjustable-rate preferred stock are paid dividends based on an underlying benchmark – generally the U.S. Treasury bill.
What are the differences between common and preferred stock?
When considering common stock and preferred stock, it’s helpful to know the differences between them. The following are some of the key points to consider.
Voting rights
Common stock owners have voting rights. If there was a vote on the new board of directors, common shareholders would generally have a say, while preferred shareholders would typically not be able to vote.
Preferred shareholders generally don’t have voting rights, or if they do have voting rights, they are limited compared to common stockholders.
Dividends
For common stockholders, dividends are variable and are paid out depending on how profitable the company is. For example, if a company can pay out dividends in one quarter, but its profitability drops in later quarters, the company can opt not to provide dividends.
Preferred shareholders are generally entitled to receive fixed dividends, and a company may be required to pay them at fixed intervals. Dividends for preferred shares may also be cumulative, so if the company misses a dividend payment in one period, it would be paid in the next.
Growth capital
The returns on shares of common stocks are typically based on the increase or decrease of the share price, including any dividend paid out. This may give shareholders the potential for significant long-term returns.
However, preferred stock shares don’t generate returns if the stock’s price increases. So while there may be a short-term return from dividends, preferred shares have less potential for long-term growth.
Risk
If a company goes bankrupt and its assets are liquidated, common stockholders are last in line to share in the proceeds.
In the event of a bankruptcy, if there are assets, the company’s bondholders will be paid first, then holders of preferred stock. Common stockholders would get whatever is left, which may be nothing.
Potential pros and cons of common stock
Like any other type of investment, there are upsides and downsides to common stock.
Pros
- Easier to buy: Common stock may be more accessible, as more companies issue common stock than preferred stock.
- Voting rights: Common shareholders have voting rights.
- Long-term appreciation: There’s more potential for long-term price appreciation with common shares than with preferred shares.
Cons
- Higher volatility: Common stock can generally experience greater short-term volatility than preferred stock. However, this is usually balanced out in the long-term potential for return that common stock may offer.
- Diminished dividends: Investors may or may not get dividends with common shares. If common stockholders do receive dividends, they’re paid out after the dividends are paid to preferred shareholders, who receive their distributions first.
- Lower priority after liquidation: Common stock shareholders have lower priority than preferred stock shareholder when it comes to receiving a payout if the company liquidates.
Potential pros and cons of preferred stock
Preferred shares also have positive and negative characteristics that are important to keep in mind if you’re evaluating this type of investment.
Pros
- Cash flow: Investors get a more stable cash flow with preferred stock, as it provides more consistent dividend income, with fixed payout amounts and payment dates.
- Dividend priority: Preferred shareholders have first priority to receive dividend payouts ahead of common stock shareholders. Also, preferred stock generally has the potential for larger dividends compared to common stock shares.
- Claim on assets: If a company liquidates, preferred shareholders have priority over common stockholders to claim the company’s assets.
Cons
- Lack of voting rights: Preferred shareholders generally don’t have voting rights, whereas common stockholders do.
- Liquidation issues: If you want to sell your preferred shares, you may find it more difficult to liquidate them if you can’t find a ready buyer.
The bottom line
Whether it makes more sense to buy common stock or preferred stock ultimately depends on an investor’s goals. Common shares typically provide greater potential for higher gains, but with higher risk. Preferred shares may be a better option for investors seeking consistent dividend income (higher than what you’d typically get with common stock) over time with less volatility.
Regardless, investing always involves the risk of a loss of principal. Working with a financial advisor can help you align your financial plan to your goals.
Common stock vs. preferred stock FAQs
An investor may be offered a set dividend each year based on a stock’s par value. For instance, if an investor is guaranteed a 7% dividend on preferred stock, and the stock’s par value is $100, they would be guaranteed an annual dividend of $7.
It may be possible to convert some preferred stock to common stock under certain conditions, when companies offer convertible preferred stock to shareholders, but in most cases it’s not possible.
Investors buy preferred stock the same way they would purchase common stock – through an online brokerage account or a personal broker.
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Editorial staff, J.P. Morgan Wealth Management
