The Primary or Core Difference in Preferred & Common Stocks
- Preferred stock guarantees regular, fixed dividends before anything can be paid to common shareholders. Preferred dividend is a set percentage of preferred stock's par value. Unlike paying interest on a bond, preferred dividends can be missed if the company did not earn enough income in a period. However, any omitted dividends must be noted as in arrears if the preferred stock carries the cumulative feature.
Past accumulated dividends have to be paid before any current dividends. Common dividends are board-declared and can be stripped out anytime the company has a cash problem. However, a company's profits after all expenses including interest on borrowing and preferred dividends are satisfied, belong to common shareholders, giving them the most earnings potential. - Receiving stable income and bearing less risk, preferred shareholders have limited or no voting rights and thus less control in a company's business. The ownership feature of preferred stock is mainly reflected in preferred shareholders' equity contribution that does not require return of the investment principles.
Furthermore, funds in the form of preferred stock qualifies as core capital or "tier 1 capital," the least risky part of a company's financing, reaffirming preferred stock's status as ownership equity. Common shareholders take full responsibility of a company's ultimate success or failure and therefore have total control of its business with one vote per share. Investopedia.com refers to common stock simply as voting equity. - Preferred stock is bought mainly for receiving fixed income rather than price appreciation. In general, company growth has little effect on preferred stock trading because any increased earnings does not really go into preferred shareholders' accounts, although a healthier company ensures dividend payments. However, some preferred stock has a feature called participation in which preferred shareholders can participate in a company's profit-sharing with common shareholders beyond receiving dividends, but only after the company's earnings have hit a predetermined threshold. And that may influence trading in preferred stock. Like bonds, change in market interest rate also affects the value of preferred stock. But the real trading volatility is in common stock whose price rests largely on earnings growth.
- In the event of a company's liquidation, preferred shareholders are senior to common shareholders in claiming any liquidation proceeds. Based on issuance terms, preferred shareholders may get more than their shares' face value amount, putting common shareholders further back in line.
Moreover, liquidation preference may also contain terms that give preferred shareholders rights to further participate with common shareholders in the distribution of liquidation proceeds after initial payments, a scenario referred to as "double dip" by a Massachusetts Institute of Technology publication on preferred return. It is widely recognized that, in a liquidation proceeding, common shareholders lose the most. - The core differences between preferred stock and common stock make them contrasting investment choices for investors with different investing goals and priorities. While common stock offers higher return with higher risk, preferred stock seeks a more balanced risk and return. At a manageable risk level with price stability and liquidation protection, preferred stock still provides a dividend rate that is higher than rates on many other fixed-income securities such as bonds, and a stable source of income when compared to the uncertainty of common dividends. On the other hand, assuming higher risks, common stock affords to its investors the potential of share price appreciation and the voting rights to control a company's business.