A company issues Common Stock and Preferred Stock to raise capital for its expansion. Common Stockholders enjoy Voting rights while Preferred Stockholders do not. Common Stock offers capital appreciation and dividends, while Preferred Stock promises capital protection and fixed coupon payments.
Common stock is a security that denotes equity ownership in the company. The term “Common stock” explains that the company’s investors do not own specific assets and that all properties and assets that belong to the organization are shared between them. Common stock is included in the Shareholder’s equity section of the balance sheet. Holders of common stock are entitled to receive a share in a company’s profits through dividends and capital appreciation.
Common stockholders are also entitled to voting rights in the proportion of their stock. They can use their voting power to elect the Company’s Directors or express their take on various corporate policies. However, some companies have two kinds of common stocks-Voting and Non-Voting. During a company’s liquidation, they only receive the funds remaining after payments are made to bondholders, other debtholders, and preferred stockholders.
Preferred stock is a class of ownership with a higher claim towards profit distribution. The dividend that preferred shareholders receive is usually fixed and does not vary according to its profit. The dividend is often pegged to a benchmark interest rate like the LIBOR. LIBOR, administered by the Intercontinental Exchange, was considered the benchmark interest rate for lending amongst major global banks. However, it now stands canceled and will likely be replaced by the secured overnight financing rate (SOFR).
These dividends are expressed as a percentage of their issued value or ‘par’ and called the Coupon rate.
Preferred Stocks have limited or nil voting rights in selecting company leaders or corporate governance issues. Its characteristics are a mix of bonds and common stock, appealing to many investors. Like bonds, you can get your initial investment back if you hold the preferred stock until its maturity, typically 30 or 40 years. Preferred stock is ideal for investors who want to preserve their capital investment and want a steady stream of cash flows. Some Preferred stocks are also convertible to common stocks. This means that investors can exchange the preferred stocks for several common stocks under specific circumstances. The stock can be automatically converted at a predetermined date, or the investor can have an option to convert the stock. Example: ABC issued a preferred stock at a par of $100 with a coupon of 8.50%. It will pay out $8.5 annually or nearly $2.12 a quarter.
Below you can see Warren Buffett discussing the rationale behind issuing Preferred stock.
Pros & Cons: Common vs. Preferred Stock
Higher Return Potential
Common stocks offer profits through capital gains with limited capital protection and inherent risks. Moreover, the profits that investors can generate from an investment in common shares are unlimited. Also, common stocks, do not require payment to the shareholders. Instead, the company and its board of directors can reward the shareholders in the case of excess profits.
Ease of Investment
It is effortless to purchase and sell common stock on any stock-trading platform. It is one of the most liquid investments that you can have. Whenever you need cash, you can sell the company’s shares in the open market through any portal. Moreover, the industry has a zero-free system for share trades. You can open your account and transact in stocks at virtually no cost.
Since common stock investment offers immense liquidity, you can increase your investments when you see profit potential. Similarly, you can also sell the shares when you feel the company is not doing well.
Access to Dividends
Most companies reward shareholders in dividends when they earn an adequate profit. The common shareholders must continue to hold the stock to be eligible for dividend payments. Some companies pay monthly dividends while others pay quarterly or annually. Investing in common stock that pays dividends is one of the best ways for consistent wealth creation.
Contribution to Economic Wealth Creation
Companies raising capital through share issuance usually do so to finance their growth objectives or expand their production. The goods and services produced by the company benefits society. Thus investing in common shares helps you contribute to wealth creation and society’s welfare.
Limited Legal Liabilities
As a common stockholder, your liabilities are limited. Even if the company runs into financial trouble and owes a lot of money to its creditors, your assets are not at stake. Your liability is only limited to the amount of investment you have made in the company. Though you will run into losses if the company doesn’t perform well financially or goes bankrupt, you wouldn’t have to bear any obligations more than your stake in the company.
Last Preference During Liquidation
During a company’s liquidation process, common stock stockholders are given the least preference. The amount left after settling payment for the debt holders, creditors, and preference shareholders belongs to the common stockholders. Typically, nothing remains after all these stakeholders are paid. Hence the equity holder doesn’t have much to expect in a payout.
No Guarantee of Return
When the value of the share increases, you are positioned to earn a profit. However, in terms of dividends, there is no guarantee. Even the companies that have been regularly paying dividends have no obligation to pay them regularly. These variable dividend payments sometimes disappear during bust cycles. There is also no guarantee that the company will earn a profit. Thus, investors looking to receive fixed, regular dividend payments can face a significant setback.
Underlying Risk Elements
There is a risk involved with ownership of Common Stock as it can be highly volatile at times. Due to this, there can be a lot of fluctuation in the share prices. Common stock valuation also undergoes tremendous changes, and it becomes complicated for investors to value the stocks and judge them.
A company might be compelled to liquidate its assets to repay its creditors in the most unfortunate situation. When a company declares bankruptcy, preferred stock shareholders receive assets before Common holders. Bondholders have the first claim on their assets. After paying the bondholders, the company makes its assets available to preferred stock shareholders. After the preferred stockholders are paid, the company’s remaining assets are divided among the common stockholders.
Higher Dividend Potential
One of the most significant advantages of a Preferred Stock is its ability to pay a higher dividend than the common stock. Even if a company cannot pay dividends to all the shareholders, Preferred stockholders come before Common Stockholders.
Fixed Income Security with Ownership
It is fixed income security like bonds, but preferred stockholders also have ownership in the company. Unlike bonds, income is not just dependent on interest movements. If a company performs well, it can result in the appreciation of the preferred stock’s value.
One of the subcategories of Preferred stock is convertible preference stock. This allows Preferred stock investors to convert their holdings to common stock after the company’s board of directors’ approval. This is a lucrative opportunity for the Preferred stockholders when the Common Stock price is rising.
No Voting Rights
Unlike common shares, Preferred stockholders do not have the same voting rights. Even for common stocks to earn enough controlling rights, the investment must be enormous. However, they still have the option to receive voting rights. For preferred holders, this option is absent. The absence of voting rights is one of the compromises for the preferential treatment they get along with the status and other financial benefits.
Time to Maturity
Many preferred stocks have a specific maturity date at which the company can redeem the asset for cash at a predetermined amount. Preferred stocks are like bonds and respond to interest rate changes; they are also exposed to many time-to-maturity implications. The treatment of preferred stock investment is different from common stock with a perpetual life in the company unless the stockholder wishes to withdraw from it.
Limited Upside Potential
While investors can receive a fixed dividend on the Preferred shares, it is not a guaranteed return. Sometimes, companies focused on growth might plow back the business’s profit instead of paying dividends. Also, the share price of Preferred stock would not appreciate how common stock would. Hence, Preferred stock has a limited upside potential than common stock.
Key Points Comparison Table
|Factors||Common Stock||Preferred Stock|
|Order of Claims||Last||Second|
|Stock price appreciation||Unlimited||Limited|
|Value at Maturity||Varies||Full|
|Risk||Higher risk||Lower risk|
The Bottom Line
A company mainly focuses on common stocks for raising capital. However, when the company wants access to more capital without significantly disturbing its debt-to-equity ratio, it can issue hybrid security like Preferred Stock. Preferred shares are more expensive than bonds for a company to issue. As an investor, if you are looking at capital appreciation, Common Stock has the potential to increase rapidly. However, if you are looking for a steady stream of income with less volatile prices than common stock but with a higher potential return than bonds, you can choose to invest in Preferred Stock.