Common stocks and preferred stocks have different features which make it suitable for investors with different requirements
A company sell stocks to raise money from investors. Stocks are nothing but ownership certificates of a company.
Stocks are of two types- common stock and preferred stock. While both represent ownership of a company, there are some differences between the two. In this article, we will look at the difference between common stock and preferred stock.
What are common stocks?
When talking about stocks, most people refer to common shares. Many companies only issue common stocks, and there are more common stocks sold in the exchanges than preferred stocks. When you purchase common stock, you get partial ownership of the company. Common shares also come with voting rights. This gives common stockholders the legal right to elect the board of directors. Hence, they also have control over corporate policy and management decisions of a company.
When a company does well, the price of its common stock tends to go up. The value of common stocks can rise substantially over time. There have been cases in which the cost of a common stock has gone up by 100 times or more over a specified period. In such cases, holders of these common stocks can earn significant profits through capital gains. However, the price of common stock can also fall over some time. The price of a common stock can fall to zero in which case such a stock may become worthless.
However, when looking at the difference between common stock and preferred stock, it is essential to note that when a company fails, the common stockholders have the lowest priority when it comes to getting back any of their money. Creditors who have lent money to the company get paid back with top priority. Even if some money is left after paying the creditors, the holders of preferred stocks get paid next. This is subject to a maximum amount. Only if money is left even after that, common stockholders get paid.
What are preferred stocks?
As we have seen, preferred stocks are different from common shares. One difference between common stocks and preferred stocks is that preferred stocks do not have voting rights.
There are two main reasons why these stocks are called preferred stocks. Holders of preferred shares receive regular dividends which are higher than those received by holders of common stocks. Preferred stocks pay dividends which are agreed upon beforehand unlike common stocks which pay dividends based on how profitable the company is. A company has to pay dividends to its preferred stockholders before it pays any dividend to its common stockholders.
In some ways, preferred stocks are like a bond. They have a par value based on which the dividend is calculated. Let us say that a preferred stock is worth Rs 1,000 and the dividend is 5 percent. Then the stock must pay Rs 50 as dividend every year as long as the stock is outstanding. When it comes to risk, a preferred stock is riskier than a bond but less risky than a common stock.
Also, as discussed before, in case a company fails, and its assets are liquidated, preferred shareholders get preference over common stakeholders when it comes to getting back their money.
Unlike common stocks, prices of preferred stock are not likely to go up by much, even when a company performs well. So, the holder of a preferred stock has fewer chances of making large profits. However, holders of preferred shares are sure to get their money back if they hold it still maturity. The price of a preferred stock can also fall to zero, but chances of that happening are very less.
Preferred stocks can be of a few types. In the case of convertible preferred shares, you have the option to convert a preferred stock into a common stock. Preferred stocks may also be cumulative. This means that the company may postpone dividend payments when it is not performing well. But when the situation improves, they have to pay the dividends in arrears. This has to be done before any payment is made to common stockholders. Another type is a redeemable preferred stock where the company has the right to redeem the stock at a date in the future.
What should you choose?
Understanding the difference between common stock and preferred stock is essential to know which types of stock to buy. Investors who want a regular income should choose preferred stocks. Since preferred stockholders get dividend payment on a priority, it gives them the confidence that they will receive regular dividend payments. But in doing so, they lose the potential of earning uncapped profits that common stocks may provide.
If you are looking for potentially high returns, common stocks are for you. It is important to note that investment in common shares also come with a high amount of risk since you can lose all your money. So, you should invest in common stocks based on your risk appetite.