Common Stock vs. Preferred Stock: Which Is Better?

What is Common Stock?

Most commonly known as ordinary stock, common stock is a type of investment asset or security. Each share of stock represents a portion of ownership in the company.

Common stock is publicly traded on the stock market. Common shares have the following characteristics:

They are sold, purchased, and resold at the stock exchange. They are easy to buy and sell which gives them a transparent, publicly listed price, making them very liquid.
They pay dividends. However, the amount varies.
They give you voting rights.

How Common Stocks Work

Common stocks are issued by both private and public companies. Shares of common stock can be sold or traded in the public markets on stock exchanges, through a broker, or directly from a company.

Voting rights: Common stocks give stockholders voting rights in shareholder meetings. This gives shareholders the right to weigh in on decisions like potential stock splits, mergers and acquisitions, dividend payments, and other topics that impact their shares.

Dividends: Companies are not required to pay dividends to common stockholders. However, if a company chooses to pay dividends, common shareholders do not receive any payments until all preferred shareholders have received their payment.

Why do Companies Prefer Common Stock?

Companies use common stock as relatively quicker was raise huge amounts of capital. This stock option allows companies to expand quickly and potentially have an advantage over smaller, private companies with less financing.

In addition to it, by issuing common stock companies have a potential source of funds if they need to raise money in the future. They can turn to the market and sell more stock in a follow-on offering. That access to funding creates stability and provides a higher level of prestige for the company and its employees. This is a better way to raise funds than issuing debt which is a liability.

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Advantages of Owning Common Stock

Here are some of the commonly known benefits of investing in common stock:

It gives voting rights.
You can invest in companies with limited liability – The extent of shareholder’s liability is the amount that they put into the investment
It enables investors to invest in securities that appreciate and generate dividends over time.
It offers a higher earning potential than most other types of investment products. Even though the returns aren’t guaranteed as a shareholder, there is no limit to how much the shareholders can profit.
It can be easily purchased and sold on various trading platforms. They are highly liquid assets that can be converted into cash at any point in time from virtually every trading platform.
It can be traded in different ways to suit different strategies and goals. Traders can buy via broker, or trade themselves. They also have the option of trading online.
It also provides dividends.

Disadvantages of Owning Common Stock

Here are some of the commonly known disadvantages of investing in common stock:

Common Stockholders are the last to get paid during a company liquidation. If the organization goes into liquidation and you hold common stocks, then you are going to be the last person who gets paid.
Shareholders don’t have much control over your investment. Despite the fact that common stockholders have voting rights it is often difficult or impossible to exercise any control over this investment.
The value of the stock can fall substantially in a single day.
Companies are not required to pay dividends on common stocks. Although some companies pay dividends to common stockholders, there is no obligation for a company to take this action.
Common Stock is a long-term investment. It usually takes time to earn a substantial profit.

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What is Preferred Stock?

Preferred stock is often described as a hybrid security. It has features of both common stock and bonds. It combines the stable and consistent income payments of bonds with the equity ownership advantages of common stock, including the potential for the shares to rise in value over time.

Preferred stocks can be traded on the secondary market just like common stock. But it is not always the case that the buy and sell price will be the same. While preferred stock prices are more stable than common stock prices, they don’t always match par values.

Preferred shares have some unique features that differentiate them from other securities, which are:

In case of liquidation of the company, preferred stockholders are given preference in assets. The shares provide their holders with priority over common stockholders to claim the company’s assets upon liquidation.
They receive dividend payments. The payments can be fixed or floating, based on an interest rate benchmark such as LIBOR.
Preferred shareholders also have a priority in dividend payments over the holders of the common stock.
These shares do not give voting rights to their holders.
Preferred shareholders also have the option to convert to a predetermined number of common shares. Some preferred shares specify the date at which the shares can be converted.
They have a feature of callability. The shares can be repurchased by the issuer at specified dates.

Types of Preferred Stock

Preferred stock is a very flexible type of security. The most commonly traded preferred stock types are:

Convertible preferred stock: The shares can be converted to a predetermined number of common shares.
Cumulative preferred stock: If an issuer of shares misses a dividend payment, the payment will be added to the next dividend payment.
Exchangeable preferred stock: The shares can be exchanged for some other type of security.
Perpetual preferred stock: There is no fixed date on which the shareholders will receive back the invested capital.

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Which type of Companies Issue Preferred Stock?

There are a handful of industries that choose to issue preferred stock. The most typical industries are real estate investment trusts (REITs), banks, insurance companies, utilities, and master limited partnerships.

Why do Companies like Preferred Stock?

Preferred stock is an attractive financing vehicle for companies because it gives them a lot of flexibility:

Preferred stocks potentially offer permanent capital for a company.
Companies can miss a payment without causing a default (which in the case of debt is not possible)
Preferred stock is considered equity and not debt. Therefore, they don’t raise the debt values and improve them.
If they’re past their call date, preference stock can be refinanced. So if the interest rate is lower at the time, a company can move down to an even lower rate.

How Preferred Stocks Work?

Preferred stocks operate similarly to a bond—it pays a fixed income payment, have a par value, are callable, and can be issued with a maturity date, usually lasting 30 years or longer.

Par value: Preferred stocks are issued with a fixed par value, also known as the face value. This is the amount a shareholder would receive if they redeemed the stock by the issuer.
Call date: Issuers of callable preferred stocks give shareholders the right to redeem preferred stocks for a specific dollar amount, as stated in the prospectus, after a certain date—known as the call date.
Dividend: The issuer payout requirements depend on if the preferred stock is cumulative or noncumulative.

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Advantages of Owning Preferred Shares

Here are some of the commonly known benefits of investing in preferred stock:

Higher dividends than bonds or common stocks.
Priority claim over common stocks for dividend payments and liquidation proceeds. Investors owning preferred stock receive the first dividends.
Some preferred stock provides cumulative shares. If the organization doesn’t turn a profit for the year, then the unpaid dividends remain an obligation to the investor.
Preference shareholders have the option to trade in their preferred shares for common stock. If you invest in this option with an organization, then it allows you to trade in your investment for a fixed number of common shares.
Price stability and lower volatility than common stocks
Preferred stock receives grades from major credit rating agencies. This gives investors a higher level of confidence in their investment.
Increased financial leverage and flexibility for the issuing company

Disadvantages of Owning Preferred Stock

Here are some of the commonly known disadvantages of investing in preferred stock:

They don’t give voting rights.
Some of the preferred stocks have a specific maturity date, at which time the company redeems the asset for cash at a predetermined amount.
The guarantee of dividends might not ever get paid. Preferred stock receives a cumulative dividend when an organization reaches profitability. If the company never makes it out of the red with its finances, then it creates the possibility of never earning the expected dividends.
There is rarely any equity growth in preferred stock. The tradeoff for the lower levels of market risk with preferred stock versus common shares is that there is little movement in the equity value of the investment.

Preferred Stock Vs Common Stock

Basis for Comparison	Common Stock	Preferred Stock
Inherent meaning	Ordinary shares with voting rights and the right to receive dividends.	Preferred shares without voting rights but a condition to receive preferential dividends;
Voting rights	Common stockholders have voting rights on various issues of the business.	Preferred stockholders don’t have any voting rights.
Dividend distribution	Common stockholders don’t always receive dividends.	Preferred stockholders always receive dividends at a fixed rate.
Priority	Common stockholders are not given priority since they are considered owners of the company.	Preferred stockholders are paid after the debt-holders but before the common stockholders.
Transferring right	Not given	Given.
Sharing of profits/loss	If there’s no profit, common stockholders receive nothing.	Irrespective of making profits/incurring losses, preferred stockholders receive the dividend.
What about arrears?	Don’t receive arrears in the next year.	Receive arrears in the next year.
Possibility of growth	Very high.	Pretty low.

One of the main differences is that common stockholders don’t receive the dividend until the preferred stockholders receive it. Also, common stockholders don’t receive the dividend at a predetermined rate. Preferred stockholders receive the dividend at a predetermined rate.
The value of common stock grows with the company. That means the growth potential of common stockholders is vast and higher. On the other hand, the preferred stockholders’ growth potential is fixed.
Common stockholders have voting rights and can vote on the critical issues of the company. Preference stockholders don’t have any voting rights.
In case of 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 in the next year.
The preferred stockholders are paid before the common stockholders.

How to Choose?

Deciding between investing in common stock or preferred stock needs some homework and careful evaluation of the key factors of both common and preferred stock before purchasing.

Common stocks have voting rights. While preferred stockholders give up this right in exchange for consistent dividend payouts.
Investors with a long-term investment horizon often favor common stocks. This is because the value of common stock has the ability to significantly increase in value over time if a company is successful. Whereas, investors with short-term financial needs should choose preferred stock because of its steady dividend income.
Common stocks are considered riskier investments because of their tendency to fluctuate in value. Also, in case of bankruptcy preference shareholders are paid up first and chances are common stockholders might receive nothing.

Both preferred and common stocks are an investment security and both carry their risks including investment risk, interest rate risk, and capital risk. Therefore, investors should carefully consider their long-term financial and investment goals before purchasing shares of a company.

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Conclusion

In the end, it’s a personal decision as to which stock is better.

Most investors buy stocks as a long-term investment. Therefore, common stock is usually the better choice because they offer a higher chance of increasing in value. However, investors should consider their ability and willingness to hold the stock for this long.

On the other hand, if an investor is looking to generate income, preferred stock may be a good choice, especially when interest rates are low, resulting in lower yield. With fixed dividend payouts that are more reliable and usually higher than common stock dividends, they can be very attractive.

Another attractive approach will be to invest in both. This will give the investor’s portfolio the good and bad of both categories of stocks. Investors can buy common stocks of a growing company and preferred stocks of a mature company. This will help you get the benefits of both and mitigate one with another.

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Back

Common Stock vs. Preferred Stock: Which Is Better?

What is Common Stock?

How Common Stocks Work

Why do Companies Prefer Common Stock?

Advantages of Owning Common Stock

Disadvantages of Owning Common Stock

What is Preferred Stock?

Types of Preferred Stock

Which type of Companies Issue Preferred Stock?

Advantages of Owning Preferred Shares

Disadvantages of Owning Preferred Stock

Preferred Stock Vs Common Stock

How to Choose?

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