Corporations issue shares of stock—also known as “equity financing”—as one method to fund their expansion or growth. In doing so, the company receives capital while shareholders become part owners of the business.
More specifically, companies issue two types of stocks: common and preferred. While each represents company ownership, it’s important to familiarize yourself with key differences before purchasing one or the other. Let’s explore these in more detail…
An overview of common stock
When you own at least one share of company stock, you become an official company shareholder—giving you voting rights on corporate policies and the ability to elect the organization’s board of directors.
A share of common stock also generally outperforms other types of ownership equity over the long term and can thus generate significant returns for investors (making this an attractive investment). Common stock is also sometimes the riskiest option, however, as its price is often more volatile than preferred stock and—in the event of bankruptcy—shareholders have a right to company assets only after bondholders, preferred stockholders, and other debtholders are paid in full.
An overview of preferred stock
Boasting features of both common stock and bonds, preferred stocks are more of a hybrid investment option. As with common stock, they are purchased in the same way and pay out dividends (though businesses can choose whether or not and how much to pay common stockholders). Preferred stocks also behave similarly to bonds in that dividends are agreed upon and paid at regular intervals, and the market value of preferred stocks is also sensitive to interest rate changes.
One advantage of preferred stocks is that they pay a higher dividend rate than common stock issued by the same company. Moreover, the issuing company must pay out preferred stock dividends before doing the same for any common share dividends, and preferred stockholders rank higher than common stockholders in the event of liquidation. These benefits speak to why preferred stocks are generally considered less risky than common stocks.
Nevertheless, preferred stock shareholders usually don’t have voting rights (unlike their common stock counterparts) and therefore have no say in electing the board of directors or voting on corporate policy.
Types of preferred stock
Preferred stock comes in various shapes and sizes. Let’s go ahead and discuss some of the most common options for the sake of brevity…
First up are callable stocks, wherein the issuing company has the right to buy back the stock at a fixed price after a predetermined date (often after a few years). These stocks pay a relatively higher dividend to shareholders—as they take on the added risk of potentially losing out on future profits—and give the company added protection from fluctuating interest rates from an issuer perspective. For example, if interest rates drop and the company can issue new callable preferred shares at a lower rate, said company can redeem outstanding shares and reduce capital costs. Conversely, should interest rates rise, shares likely won’t be redeemed and the issuer will continue paying the lower rate.
Convertible preferred stocks give investors additional protection by allowing them to convert preferred shares into a predetermined number of common shares at some point in the future. These types of stocks are often associated with early-stage companies in the midst of a rapid expansion.
Conversions can happen in several ways. You may have the right to exercise this option whenever you’d like (the most common option); alternatively, the stock may contain a provision dictating an automatic conversion at a predetermined date or allowing the board of directors to vote for one. The stock’s prospectus (a document containing investment details) lays out conversion specifics in this case.
Cumulative preferred stocks, which allow companies to suspend dividends when they can’t afford to pay them, protect investors in that unpaid dividends must be repaid before any dividends are paid to common shareholders. For example, if a company guarantees dividends of $1 per share and can’t afford to pay this for two consecutive years, it must pay a $3 cumulative dividend in the third year before doing so for any other dividends.
Participatory preferred shares provide shareholders with an additional guarantee. Should the company meet specific financial goals (e.g., a revenue or profit target), shareholders will receive dividend payments above the normal fixed rate. This type of investment is best suited for investors who believe the company is well-positioned for unusually strong earnings or primed to be sold for a high price.
Finally, adjustable-rate preferred stocks (ARPS) pay out a dividend rate tied to a common benchmark: often a U.S. Treasury bill. As a result, the dividend is modified—typically on a quarterly basis—with this flexibility making adjustable-rate stock prices more stable than fixed-rate preferred stocks and protecting the company (as this type of stock has caps that prevent the issuer from paying inordinately large dividends). ARPS are best suited for conservative investors, with their stability shining through as a top selling point.
Terms and other details to know about preferred stock
As with common stocks, you can invest in individual company preferred stocks, preferred stock mutual funds, or preferred stock exchange-traded funds (ETFs).
Be sure to familiarize yourself with a few key terms before investing in preferred stock:
Dividends—company payments to shareholders—are based on earnings and issued in the form of cash, stock, and special dividends (which occur on an infrequent basis). As a result, these are typically paid out by more well-established companies that don’t need to reinvest their money.
The issuing company pays dividends based on a percentage of the par value—the stock price stated in the company charter—typically at a fixed rate. Thus, if the par value of the stock is $25 and the dividend is 3%, the issuer must pay $0.75 annually for as long as the preferred stock is outstanding.
Current yield represents the expected annual return an investor would enjoy by purchasing the stock. One must know the annualized dividend and divide that by the market price of the stock to compute this (e.g., if the current market rate is $25 and the annualized dividend is $0.75, the current yield would be 3%).
Preferred stock benefits
The biggest selling point for preferred stocks is that they can offer steady income via interest or dividend payments while also boasting higher yields than other traditional fixed-income investments (such as bonds). Additional reasons to purchase preferred stocks? They are less risky than common stocks and enjoy a higher level of price transparency than bonds because they’re traded on the stock exchange. Preferred stocks are thus often an excellent way to diversify your portfolio given these benefits.
Common vs. preferred stock: which should you choose?
If you’re on the hunt for an investment with high-upside price potential and can stomach higher share price volatility, common stocks are perhaps best suited for you. These are also favored by investors with a long-term investment horizon as their value can grow significantly over time in light of company success.
Alternatively, if you’re more risk-averse and looking to maximize dividend income, investing in preferred stock is a great way to go.
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Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.
There is no assurance that the techniques and strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal. Preferred stock dividends are paid at the discretion of the issuing company. Preferred stocks are subject to interest rate and credit risk. As interest rates rise, the price of the preferred falls (and vice versa). They may be subject to a call feature with changing interest rates or credit ratings. Dividend payments are not guaranteed and may be reduced or eliminated at any time by the company.
