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How are common stocks different from preferred stocks?

10 Mins 01 Jun 2023 0 COMMENT

Introduction

Investors keen on acquiring an ownership stake in a company can choose between two types of stocks – common stock and preferred stock. While both of these types of stocks represent ownership in a company, there are some key differences between the two.

What are common stocks?

Common stock is the most issued type of stock that investors buy. In order to avoid confusion, one must note that in any conversation about stocks, the word ‘shares’ refers to these common stocks.

When you buy common stock, you are buying an ownership stake in the company. As a holder of common stock, you are conferred with the right to vote on certain company matters. Usually, the common stock owner gets 1 vote per share owned and it proportionally rises as the number of shares held increases.

Moreover, holders of common stock are also entitled to a commensurate share of the company’s profits, which are paid out in the form of dividends. These dividends are not guaranteed, however, and can fluctuate based on the company's performance. Should the company miss any dividend payment, it will give preference to ‘preferred share’ holders over ‘common share’ holders when the board of directors decides to disburse payments.

More importantly, if a company goes into insolvency, holders of common shares are the last claimants of the company’s assets. This means that when the company liquidates its assets for repayments, common shareholders are not handed payouts until preferred shareholders are paid.

Common stockholders can also make a profit by selling their shares at a higher price than that paid to buy them. The price of common stock can fluctuate in the stock market based on various factors, such as the company's performance, industry trends, and overall market conditions.

It is important to note that common stocks are not convertible to any other form of stocks – a feature that is allowed in preferred stock.

What are preferred stocks?

Preferred stock, on the other hand, is a type of stock that comes with some additional benefits but no voting rights. When you buy preferred stock, you are still buying an ownership stake in the company, but your rights as a shareholder are slightly different.

One of the primary benefits of owning preferred stock is that you are entitled to a fixed dividend payment. Unlike common stock dividends, which fluctuate based on the company's performance, preferred stock dividends are typically paid at a fixed rate. In that regard, preferred shares work in a similar fashion as bonds.

Over and above the fixed dividend payment, preferred stockholders also have priority over common stockholders when it comes to receiving dividends. This means that if a company needs to cut back on its dividend payments, preferred stockholders will receive their dividends before common stockholders do.

Another key difference between common stock and preferred stock is voting rights. While common stockholders have the right to vote on certain company matters, preferred stockholders typically do not have any voting rights. This means that if there is a major decision that needs to be made about the company, preferred stockholders will not have a say in the matter.

Despite the lack of voting rights, preferred stock is still a popular choice for some investors because of its relative safety compared to common stock. Since preferred stock dividends are typically fixed, they offer a stabler income stream than common stock dividends. This can be lucrative for investors looking to generate a dividend income on their investments.

Another benefit of preferred stock is that it often comes with a call feature. This means that the company has the option to buy back the shares of preferred stock at a predetermined price.

Now that we have discussed what common stock and preferred stock are, what is the difference between common stock and preferred stock? Let’s understand.

Differences: Preferred Stock vs Common Stock

  1. Voting Rights: Common stockholders have the right to vote on certain company matters, while preferred stockholders typically do not have any voting rights.
  2. Dividend Payments: Common stock dividends are not fixed and can fluctuate based on the company's performance. On the other hand, preferred stock dividends are fixed and paid out at a predetermined rate. Preferred stockholders also have priority over common stockholders.
  3. Priority: Preferred stockholders get priority on payment of dividends over common stockholders. Additionally, if a company goes bankrupt, the proceeds from liquidating its assets are disbursed to preferred stock owners before common stock owners.

While both types of stocks, common stocks as well as preferred stocks, represent the ownership in the company, they differ in their characteristics and the rights and privileges they provide to the shareholders. It is essential for investors to understand the key differences between common stocks and preferred stocks to make informed decisions when choosing which type of stock to invest in based on their investment goals and risk tolerance.

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