By: Alex Dixon – Content Specialist
Shares of stock come in two primary classes: common stock and preferred stock. But what is common stock vs. preferred stock, and someone may even ask “How do I know the difference between common and preferred stock?”
Common stock is a security or form of investment that represents ownership in a company. Some of the attractive things about common stock is that common stock shares typically yield higher rates of return over the long haul than preferred stock or debt instruments and owners of common stock get to participate in certain aspects of the company, like electing a board of directors and can vote on corporate policies. Of course, what catches most people’s attention is the higher rates of returns over time, at least historically. This is because common shares are basically at the bottom of the payout priority when it comes to debt and dividend payments, making price fluctuations most likely.
Preferred stock, like common stock, represents ownership of a company, but also acts like bonds or a debt instrument in some ways. For example, preferred stock has fixed dividends that must be satisfied prior to any dividends going to common stock shares. Preferred stock dividend payments come after bond and other debt payments. With this fixed dividend payment, preferred stock shares tend to trade at a more stable price over time, which is why over time they tend to yield lower returns compared to common stock. Preferred stock also carries no voting rights, so preferred shareholders have basically no say over the issuing company’s management. Preferred stock is like Bonds and are even rated for financial stability like bonds in that they have a consistent, pre-determined pay out.
Common stock shares generally yield a higher return and preferred stock shares generally yield a lower risk. Preferred stock almost acts like a hybrid between common stock and debt instruments like bonds. Preferred stock may still benefit from valuation like common stock, and gets priority over common stock in dividend payouts and in the during a liquidation, preferred stock get claims on assets before any common stock. Due to this lower risk, preferred stock generally yields a lower return.
WHY COMPANIES ISSUE COMMON STOCK
Companies issue stock to raise funds without going into debt. Common stock exchanges partial ownership of the underlying company for capital that they can use for their day-to-day operations, specific projects, or anything they choose. Rather than having a debt obligation to the investor as with bonds, companies share their ownership among whoever wants to invest.
WHY COMPANIES ISSUE PREFERRED STOCK
Companies issue stock to raise money. In the case of both common and preferred stock, companies exchange shares of ownership to investors for capital. Companies become attracted to preferred stock because they can raise funds without issuing debt (as in the case of bonds) and distribute less control of choice in management via voting rights to investors than common stock. The companies that issue the preferred shares are the ones that come up with the terms and conditions, as such, they can put things in there which benefit the company and what they are up to. For example, the company can give themselves the flexibility to either delay or not pay dividend payments at all if the company is experiencing hard times. Perhaps the most attractive aspect of preferred stock is that the company and common shareholders retain equity of the business. The only way preferred stock obtains equity is if the shares convert into common shares or if the company performs a liquidation, the preferred shares are just after debt collectors in terms or rights to assets such as equipment, furniture and real estate.
One type of preferred stock is convertible preferred stock. This differs from non-convertible preferred stock in that convertible preferred stock offers preferred shareholders the option to convert their shares into a fixed amount of common stock, after a specific date. When preferred stock converts into common stock, the shares received are newly issued shares, which means the total number of common shares in existence increases. If the value of the underlying company remains the same, existing common share prices drop as the value is split among more shares.
As the saying goes, taxes are one of the two guaranteed things in life. Common stock valuation pays taxes at capital gains rates, which are typically lower than ordinary income and can vary based on the length of time the capital gain took place. The taxes for valuation of preferred stock is just like common stock but the dividend payments could be taxed as either capital gains or ordinary earned income. Before deciding on an investment, make sure you understand how the taxation for the product you are investing in works. Taxes can also be treated differently in corporate accounts, education accounts, and retirement accounts. For example, dividends in traditional Individual Retirement Accounts (IRAs) pay taxes when the funds are withdrawn, not when they accumulate.
CUMULATIVE AND NON-CUMULATIVE
When referring to cumulative and non-cumulative and talking about stocks, this refers to dividends. Cumulative securities generally mean that the issuer of the stock misses dividend payments because of hard times or any other reason, those payments are still due to the stock owner(s) through obligations laid out in the terms of the preferred shares. Non-cumulative means that the issuer has no obligation to reimburse missed dividend payments. Of course, the issuing company of the stock can come up with a variety of agreements with varying payment terms and conditions. This is another important point on investors doing research before purchasing any investment.
For investors wanting to potentially yield the highest return possible for company valuation and greater liquidity, common stock is probably the most attractive form of stock. For investors seeking a more consistent valuation, but still would like to experience stock appreciation and a reliable source of income, preferred stock is something to consider looking into. Both stock forms are company ownership, but common stock grants shareholders voting rights while preferred stock generates a fixed dividend amount and has a higher priority during a liquidation. Preferred stock has features that are found in debt instruments, like bonds, and are a hybrid investment. One of the major variations of preferred stock is that cumulative or non-cumulative both exist. Having different securities and fixed income vehicles in your investment portfolio helps in the financial industry, make sure that you build your portfolio so that it maximizes what you are seeking to carry out.