Investors who are looking to purchase stock in a company are faced with a whole laundry list of decisions to make. One of these decisions – and a very important one – is whether to purchase common or preferred stock. In order to determine which is the best fit for your portfolio, it’s important to understand the difference between common and preferred stock and the potential pros and cons of each. Read on to learn more.
Common stock is what you probably think of when you think of stocks. Holders of common stock make or lose money based on the rise and fall of share prices. They get paid dividends and can vote on corporate issues. The biggest downside to common stock is that it can be volatile, and if a company goes bankrupt, common stock holders have very little chance of regaining their capital, since they are the last to be paid out.
Preferred stock holders are paid a predetermined dividend, instead of the amount varying like it does for holders of common stock. Typically, this dividend is higher than what common stock can give, but that can change if the company’s shares begin to do very well and common stock dividends rise. Because preferred stock dividends are already set, they won’t change or rise when the company does well. Preferred stock has a blend of the securities and downfalls of both stocks and bonds – it’s often referred to as a hybrid security. Another perk of preferred stock is that they are higher on the list to be paid out in the event of a company going bust, so they have a better chance than those holding common stock to regain some capital. Preferred stock is also referred to as preference shares.
The dividends on the preferred shares are also more secure than the one on the common stock if the company falls into bad times. A company may choose to discontinue paying dividends on the common stock. However, if the company misses paying a dividend on its preferred stock, they are obligated to accrue the dividend and pay it out eventually.
Some preferred stocks are callable. This means that the company is able to buy back the shares at a predetermined price.
Pros and Cons: Preferred Stock Vs Common Stock
The fixed dividends paid to preferred stock makes it more stable than common stock in most instances, but it is still far more volatile than a bond. Common stock tends to rise in value much faster and far more easily if the company does well, but it will crash just as quickly and just as hard if the company fails. All in all, preferred stock is a good source of stable income, but common stock will probably yield a higher return.
Keep in mind that if you are concerned about your tax exposure, most of the return from the preferreds will come from its dividend yield, which may be taxed at the higher income tax rate. Stockholders of the common are likely to get a significant portion of their returns in the form of capital gains that may be tax advantaged. Check with your tax advisor on your specific situation and the rules that are in force at the time you invest.
In the end, both types of stock can have their strengths and weaknesses, just like with any kind of investment. Look into the details of the stock you are considering purchasing in order to determine the best blend for your financial investment portfolio. Compare and contrast and also be cognizant of which asset fits your investment strategy better.
Why Would a Company Issue Preferred Shares?
Many companies find preferred stocks attractive as it gives the best of both worlds between stocks and bonds. For example, preferred stock is a way of getting equity financing without giving up voting shares or business collateral. It also helps the management in managing the debt to equity ratio lower. Investors tend to be more receptive to issuance of new preferred stock as it does not dilute the existing equity holders in the manner issuing a common would do. Many investors also prefer the stability and lower risk of preferred and a predictable dividend.
Why Would You Buy Preferred Stocks
The seniority of the preferred shares is a very valuable attribute. Sometimes you may want to invest in a company that may be under duress and therefore the common shares may be riskier than you may wish. During these times, it may be a worthwhile option to consider the preferred shares, if the company has any outstanding. The dividend is more secure, and when the times are not good, the preferred shares may lose in value and take on the characteristics of a common stock (higher potential returns for lower risk).
What is the Downside of Preferred Stock?
Preferred and common stock differ in the amount of shareholder control they bestow. Preferred shareholders do not have a say in the corporate decision making to the extent common stockholders do. Preferred stock is also not conducive to rapid fire trading that many investors do as it does not have as much liquidity as the common. Finally, if a preferred is callable, it can create unpredictable dynamics for the preferred shareholder based on changing company strategies.
Preferred stocks offer another type of investment opportunity to the shareholders and should be part of your tool set. These two stock types bring their own sets of advantages and disadvantages. You will need to balance your goals and strategies to determine which one of these two stock types fit your specific requirement.