The Difference between Common and Preferred Stock

With the purchase of stock (common and/or preferred), an investor acquires a share of ownership in a corporation.

Nonetheless, there are also significant differences between common stock and preferred stock. Ones that are relevant to the investor interested in purchasing stock from a publicly held corporation. According to the literature, these differences entail: 

(1). Dividends

Payments that a corporation distributes to its stockholders are called dividends. Dividends come from the corporation’s profits or retained earnings: usually the company’s dividend policy determines the payment.

Corporations pay dividends on a per share basis: The more stock in the corporation, the greater the share of profits.

From a Canadian perspective, with the purchase of common stock, the investor is entitled to a share in the financial benefits of ownership.

However, with this stock the dividend payment is contingent to some degree on the ultimate financial status of the corporation. The company’s capacity to expand, to maintain its earnings, its sustainability, the market (and so on) all impact the ongoing payment of dividends.

For example, as earnings increase, so does the dividend payment, although most corporations do not guarantee this. The more money the company makes, the more the common shareholder may benefit.

Then again, if business takes a downturn or the Board of Directors invests profits in tangible assets (e.g., new equipment, buildings) there may be a reduced dividend payment or neither one at all. In short, the size and timing of dividends can be uncertain.

With preferred stock, holders regularly receive a fixed dividend. Comparable to how the interest payment on a bond is predetermined, so is the dividend of this investment.

In fact, these shares are guaranteed to pay, (that is when there are dividends to be had). In this regard, some contend that preferred stock is to all intents and purposes a perpetuity providing a level cash flow.

Moreover, the corporation must pay the stated dividend rate on preferred stock prior to paying dividends on common stock. Although payment of dividends cannot be assured, generally they must be distributed to preferred stockholders before common shareholders.

(2). Voting power.

Shares in a corporation can be voting or non-voting stock. Voting stock provides the shareholder with a vote on corporate matters (e.g., financial operations, election of the board, mergers, and so forth) at the annual general meeting (or AGM).

Investors who purchase non-voting shares have no vote (or minimal) on corporate matters. Such shareholders may want to invest in the corporation’s profitability, and not be involved in corporate governance.

Common stock does confer to the holder a say in the management of a corporation. Generally, one share of common stock equates to one vote. The more stock , the more votes.

For the majority of stockholders this power is minimal, voting rights limited. However, some stockholders are entitled to more votes as well as higher dividend payments, and greater rights to assets.

This is because not all common stock is equal. Investors can purchase subclasses (e.g., Class A, B, and C) in common (and preferred) stock.

Each class has a specific performance, risk, and load level of investment. For example, Canadian Class A shareholders have more powerful voting rights, higher dividends, and so forth than other classes.

Generally, owners of preferred stock do not have a say in company decisions and/or management. Whereas preferred stock usually carries no voting rights, the owner of this stock is not entitled to vote at the corporation AGM.

(3). The degree of risk and the return on the investment.

It is impossible to realize a return on any investment without facing some degree of risk. The reality is that no investment can be guaranteed risk free, the value of a guarantee only as good as the guarantor.

Depending on the nature of the investment, the risk will vary. Nevertheless, generally, the higher the risk, the greater the potential monetary return, greater the potential loss. Money quickly earned, can be quickly lost.

This is another of the differences between common stock and preferred stock. According to the literature, although investing in common stock has the potential for great returns, there is also greater risk. In short, common shares have more risk then preferred stock.

Preferred shares are a more stable investment, promising regular revenue. With this safety, however, comes a price. The interest is lower than for common shares and as such, there is not the potential for the monetary return as with common stock.

Bankruptcy, Liquidation, and/or Other Business Catastrophe

Stocks enable investors to participate in a business without being subject to the downside of individual owner or partnership. The reality is that when catastrophe happens to unincorporated businesses, in most cases creditors can lay claim to the personal assets of the owner (e.g., house, car furniture).

To contrast, when corporations fail, stockholders are not personally liable for business obligations. Stocks do offer limited liability: In most cases, the greatest loss shareholders can incur is their initial investment.

In the event of bankruptcy, upon liquidation, the ranking of those who have claim to the assets and incomes of the corporation are corporate bondholders, then preferred shareholders, lastly common stock holders.

Note that holders of preferred stock have priority over (and a greater claim) than common shareholders. This is because preferred stock is usually secured in the event of corporate bankruptcy.

Not so for common stock; It is not guaranteed. These stockholders have what is known as a residual claim.

This means that they are the last in the line. Common stockholders have a claim to whatever is left only after all other claimants – bondholders, preferred stockholders, creditors, employees, and so on.

Final Point

To generate capital, publicly held corporations frequently issue securities. These instruments are then traded to investors for the desired funds.

Common stock and preferred stock are but two of a number of such equity investments that an individual can purchase. Although both signify ownership in a corporation, there are significant differences between common stock and preferred stock. There are benefits and costs involved with each.

The onus is on the investor: After all it is your money. The equity market is very unpredictable, filled with risk. Although it has yielded huge returns for a lot of investors (both the lucky and the astute), it has destroyed just as many financial dreams.

(References available upon request.)