The Beginner's Guide to Common & Preferred Stocks
Common and preferred stocks are different in a few key aspects, with big implications for trading and investing.
Published May 8, 2024.
In the world of trading and investing in stocks, there are two primary types of stocks: common and preferred. Although they somewhat overlap, a few key differences might make or break any investor's goals.
So, let's examine the basics of common and preferred stocks and see what sets them apart, like who gets paid first when dividends are distributed and whether shareholders have a say in company decisions.
Understanding these differences will equip you to make smarter choices that align with your financial goals.
Note: The information in this blog is purely educational and should NOT be considered advice.
What Are Common and Preferred Stocks?
Common stocks are ownership shares in a company that bring voting rights to shareholders. The rights sometimes come with a portion of the company's profits, meaning dividends, but these are not guaranteed.
Preferred stocks also come with ownership but typically do not have voting rights. Instead, these stocks bring higher claims on assets and earnings than common stocks, including fixed dividend payments.
The Differences Between Common and Preferred Stocks
Voting Rights: Common stockholders usually have the right to vote at shareholder meetings, while preferred stockholders typically do not.
Dividends: Preferred stocks often have fixed dividend rates and more predictable income, while dividends for common stocks can vary and are not guaranteed.
Priority: In the event of a company’s liquidation, preferred stockholders hold higher priority over common stockholders in asset distribution.
Key Definitions & Terminology
Ownership Stake
The ownership stake is the fraction of a company owned by a shareholder. It is directly proportional to the number of shares the stockholders hold compared to the total outstanding shares.
Ownership stake includes a portion of the profits (through dividends and capital gains) and influence on corporate decisions through voting.
Voting Rights
Voting rights mean that shareholders can influence corporate governance and strategic directions. They do this by casting votes on important company matters, like the election of board members and significant policy decisions.
Dividend
A dividend is a payment that a corporation makes to its shareholders. A company typically uses its profits and distributes a portion back to its investors.
A dividend yield is the percentage of a share’s value that an investor receives annually or quarterly. For example, if a stock is worth $100 and has a dividend yield of 2%, it would pay out $2 annually per share to its investors.
Dividend Preference
Dividend preference is seen in preferred stocks, and it ensures that holders receive dividend payments before common stockholders. This is typically achieved by fixed dividend rates.
Preferred stockholders have a more predictable and stable income stream, regardless of the company's financial performance.
Yield
A yield is an annual return on an investment, expressed as a percentage of the investment's cost.
It measures the generated income relative to the price paid for the investment. This allows for comparison across different securities.
For stocks, the yield is calculated by dividing the annual dividends paid by the current market price of the stock. If a preferred stock pays an annual dividend of $5 and its current market price is $100, the yield would be calculated as follows:
Yield = (Annual Dividend/Market Price) x 100 = (5/100) x 100 = 5%
Conversion Features
Conversion features are specific options in some of the preferred stocks.
They allow holders to convert their preferred shares into a specific number of common shares, usually at the shareholder's discretion.
This feature allows for potential capital appreciation by converting preferred shares when the price of common stock is favourable.
Liquidity
Liquidity refers to the ease with which common stocks can be bought or sold in the market without significant price changes. In simple terms, more liquidity means more money is available for buying and selling.
High liquidity translates to smoother transactions and more accurately reflects a stock’s market value.
Common Stocks Overview
Common stocks are often used for growth. Issuing common stocks lets companies raise capital from public investors, which funds expansion, operations, and other strategic initiatives.
This equity financing method dilutes ownership,, but the company doesn't have to repay the capital or make fixed-interest payments.
Examples of common stocks include:
Apple Inc. (AAPL): A technology giant known for innovating in consumer electronics and software.
Amazon.com Inc. (AMZN): A global e-commerce and cloud computing company impacting various sectors.
Common stocks are subject to market volatility. Their value is influenced by:
- Company’s performance
- Market conditions
- Economic factors
Preferred Stocks Overview
Companies use preferred stocks to raise capital without diluting voting rights.
Preferred stocks appeal to investors seeking more predictable income streams without direct involvement in company governance.
Examples include:
Bank of America Corp (BAC): Offers preferred stocks with various dividend rates and terms, appealing to investors looking for fixed-income securities.
AT&T Inc. (T): Issues preferred stocks as part of its capital structure, providing an alternative to common stocks for income-focused investors.
The yield on preferred stocks is influenced by several factors, including:
- Current interest rates
- Company’s creditworthiness
- Overall demand for the stock
For example, higher interest rates can make preferred stocks more attractive. The rates could potentially reduce the market price and increase the yield of existing preferred stocks.
At the Intersection of Common and Preferred Stocks
Common and preferred stocks are used for different investment and trading goals. The common ones work for investors who want a say in the company's decisions and growth; the preferred ones suit income-oriented investors more.
Still, a choice between the two is not the end-all. Thanks to conversion features, you can always move preferred to common stocks, depending on market conditions.
However, before opting for either, make sure to do thorough research on the market and the company.
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