Common Stock and Preferred Stock: Meaning & Differences
Common and preferred stock are the two main types of shares that a business sells to raise capital. Investors usually purchase these shares to enjoy dividend payments, capital appreciation, and voting rights.
Each of these stock types offers unique benefits to its holders. The shares that are regularly traded in the stock markets every day are common stocks.. Let us know more about common stock and preferred stock in detail!
What Is Common Stock?
Common stock is a type of security representing individuals’ ownership in a company and their claim on the accrued profits of the same. It allows individuals holding this stock to enjoy voting rights at business meetings for formulating corporate policies and the opportunity to receive dividends.
Moreover, on the company’s liquidation, these stockholders receive a share of profits after paying all creditors and preferred stockholders.
What Is Preferred Stock?
Preferred stocks are securities representing ownership in an entity, combining aspects of both common stock and bonds with regular income and company ownership. Although they do not come with any voting rights, holders get priority when it comes to claiming the company’s profits. Moreover, it is possible to convert some preferred stocks into a predetermined number of common stocks.
What Are the Differences Between Common Stock and Preferred Stock?
The differences between common stock and preferred stock have been explained below:
- Voting Rights
Although both common and preferred stockholders are entitled to own a part of the entity, they do not share the same voting rights. Only common stockholders are given the right to vote, whereas preferred stockholders do not have such rights.
- Payment of Dividends
Both common and preferred stockholders may receive dividends, but the nature of payment differs from one another. In the case of preferred stockholders, the dividend payment is mandatory and mostly fixed. Moreover, they are prioritised over the common stockholders and paid before them.
On the contrary, common stockholders do not get fixed dividends and are paid only after paying creditors and preferred stockholders.
- Stockholders Priority
Bondholders are the first to receive payment when a company earns profits, and common stockholders are the last. As preferred stockholders have the characteristics of both bond and common stockholders, they are paid before common stockholders and after bondholders. In any scenario, common stockholders are paid last in line.
- Stock Conversion
Preferred stock is convertible to a fixed number of common shares, but common stock cannot be converted to preferred shares.
- Distribution of Profit and Loss
An individual investing in preferred stocks will generally receive dividends, regardless of the company’s profit or loss. However, in the case of common stockholders, dividends are not guaranteed.
- Growth Possibility
The growth potential in the case of preferred stocks is low as the shareholders are paid fixed dividends. On the contrary, the growth possibility for common stockholders is very high so is the risk associated with it, especially if the company expands its business exceptionally.
- Claim on Arrears
Preferred stockholders usually get back their payments in the following financial year, generally in the form of dividends. On the contrary, common stockholders might not get their unpaid dividends in the following year as dividends are not guaranteed.
Let us discuss the differences in a tabular form for easy understanding:
|Basis of Comparison||Common Stock||Preferred Stock|
|Voting Rights||Shareholders have voting rights||Shareholders do not have voting rights|
|Payment of Dividends||No fixed dividends||Mandatory and mostly fixed|
|Stockholders Priority||Least priority||Receive payment before common stockholders but after bond or debt holders|
|Stock Conversion||Non-convertible||Convertible option is available|
|Profit and Loss Distribution||No profit is distributed if there is no benefit to the firm||Shareholders are entitled to dividends, regardless of the company’s profit or loss|
|Claim on Arrears||Shareholders do not get their unpaid dividends in the following year||In cumulative preference share Shareholders receive payments in the cumulative next year if the dividends are missed|
Also Read: Cyclical Stock: Meaning, Benefits & Examples
Which One Is Better – Common Stocks or Preferred Stocks?
If you want to invest in stocks for a longer period of time, common stock can be an ideal option due to its greater upside potential. With common stocks, you will get voting rights and can also enjoy ownership of the firm. Although these stocks have relatively higher risks, they also may generate potentially higher returns.
On the other hand, preferred stocks are ideal for you if you want to generate steady income with lower risks. These shares generally generate lower yields than common shares in the long term; however, these stocks are comparatively more secure.
Investments in both common and preferred stock involve a considerable sum of money with various risks. Thus, it is important to analyse your finances before investing. Besides, it is also important to ascertain your risk tolerance before investing in common stocks or preferred stocks. Hence, to invest safely, it is recommended to consult your financial advisor to get guidance and avoid the risk of investing in the wrong way.
Frequently Asked Questions
How to buy common stocks and preferred stocks?
For buying or investing in common and preferred stocks, it is important to have a trading account and a Demat account. As per the Securities and Exchange Board of India (SEBI), you have to have these accounts to invest in equity markets in India.
Can common stocks and preferred stocks have the same price?
No, common stocks and preferred stocks can never have the same price as the benefits provided by them are different. Moreover, preferred stocks are also convertible, which means that you can sell them at a discounted price that is much lower than common stocks.
Is it possible for a common stock to outperform a preferred stock?
It is very normal for common stocks to outperform preferred stocks as they are more volatile and may witness higher capital appreciation over time. Moreover, the return on investment in the case of preferred stocks is steady but low, similar to bonds.
What happens when a company converts preferred stock to common stock?
Conversion of preferred stocks to common stocks lets the preferred stockholders participate in the company’s increased earnings. With time, the dividend rate on common stocks may surpass the rate on preferred stocks. In such a case, converting preferred shares to common shares acts as an advantage for the preferred shareholders.