Should You Invest in Common or Preferred Stock? The Most Important Things You Need to Know
When you invest in equities, you sometimes have the choice between preferred and common stock. Most people are familiar with common stock, which is the standard investment. However, preferred stock may make more sense for some investors if it is offered by the organization.
Both forms of equity are essentially the same in that they represent a piece of ownership of the issuing company and are an investment in the future success of the organization. At the same time, the rights between holders of preferred and common stock are quite different.
There are key differences between these two forms of stock. You should understand the pros and cons of each before you make an investment.
How Purchasing Preferred Stock Differs from Common Stock
One of the main differences that you should know between preferred and common stock has to do with voting rights. With common stock, holders always have voting rights, usually with one vote per share. However, preferred stock does not come with voting rights.
This means that when the company needs to elect a new board of directors or even just vote on some new corporate policies, people who have preferred stocks have a very limited voice. In this sense, preferred stock functions much like bonds, especially since this investment comes with a guaranteed and fixed dividend in perpetuity.
Many companies do not pay dividends to common stockholders at all and, if they do, it is not guaranteed. However, preferred shareholders always get a dividend paid to them. The dividend yield of a preferred stock gets calculated as the dollar amount of the entire dividend divided by the stock price. This calculation usually happens based on par value before preferred stock even gets offered and can represent a percentage of the current market price once trading begins. Before investing, you should determine how the number was calculated.
Preferred shares also have a par value that can change based on interest rates, which is another way in which they resemble bonds. As interest rates rise, the value of preferred stock tends to fall. Likewise, when interest rates fall, the value of preferred stock will increase. This is different from common stocks, which have a price based on supply and demand in the market.
One of the key benefits of preferred stocks comes in the case of a liquidation. Preferred shareholders will get paid out prior to common shareholders. This holds true during good times when the company has excess cash and is paying dividends. Preferred shareholders will get higher dividends than common shareholders. If companies miss a dividend payment, they must pay arrears to preferred shareholders first.
Additionally, preferred stock is callable, which means that companies can redeem the shares at certain points for a set redemption rate that is a premium over the purchase price. While you will get a premium in the event of a call, you would still face reinvestment risk, which is important to think about when purchasing preferred stock.
Points to Consider When Comparing Preferred and Common Stock
Most people invest in common stock. For the most part, when people talk about equities, they are referring to common stock, and the vast majority of stock is issued as common rather than preferred. With common shares, investors have a claim to profits, which are paid out through dividends. Furthermore, common shares come with voting rights. This means that shareholders have a voice in how the company gets managed.
Most individual investors do not hold enough stock in a single company to have a significant influence. However, you need to think about how important having a say is for you as an investor. If you do not care, then preferred stock may be a better option, especially if you are set on receiving dividends from the investment.
The board of directors of a company ultimately decides whether or not to pay dividends to holders of common stock. Should a company miss a dividend payment, the common stockholders will not likely get paid, since preferred stockholders have first dibs.
Companies will always prioritize payments to preferred stockholders. This can become a significant issue during insolvency. Common stockholders are last in line when liquidation occurs. Creditors and bondholders get paid first, followed by preferred stockholders. Common stockholders are last in line.
Another important point to consider is the fact that common stock tends to perform better than preferred shares, or even bonds for that matter. Common stock also has the most potential for significant long-term earnings. As the company’s profits increase, the value of common stock tends to go up to match. However, the value of the stock can also decrease if the company does not perform as expected.
Thus, there is greater risk with common stock as preferred stock will continue to pay dividends even if the company does not continue to grow. You should also note that you can typically convert preferred shares to a fixed number of common shares at any time while the reverse is not possible.
