What is the difference between preferred stock and common stock?
Many companies issue 2 different types of stocks: common stocks and preferred stocks. Common is not a derogatory term as one might think. Rather, common stock just means that it is the standard stock that the company issues. Likewise, the name “preferred” does not mean that these shares are better, but rather it offers investors privileges and rights different from those offered by common stock. The main differences between the two are the levels of risk and privileges involved. The decision whether to invest in common shares or preferred shares is based on each individual’s personal preferences and risk tolerance.
What is common stock?
Common stocks, also referred to as voting shares or ordinary shares, are considered to be more risky and speculative than preferred stocks because they are last to receive the company’s assets. This means that if a company goes bankrupt, the common stockholders receive whatever assets are left after creditors, bondholders, and preferred stockholders have been paid in full. Common stock shareholders are also last to receive any interest and dividends.
One of the advantages of owning common stocks is that shareholders participate in the profit and growth of the company through dividends and capital appreciation. Common stockholders can be paid dividends variable with the company’s growth. If you are one to take the greater risk of owning common stocks, you could end up receiving a large amount of dividends if the company does well. However, keep in mind that the company’s board of directors decides whether or not to pay dividends, as well as the amount to pay.
Common stockholders also have preemptive rights, meaning they have the right to purchase any new shares of common stock the firm issues before any non-holders. This allows them to maintain their proportional ownership in the company. Another advantage is that common stock provides voting rights on matters of corporate policy. Shareholders’ voting rights are directly related to the number of shared owned. However, they cannot vote on dividends.
What is preferred stock?
Preferred stocks are also known as hybrid investments because they have characteristics in-between a bond and a common stock. Preferred stocks tend to be more expensive than common stocks but do not fluctuate as often. It is a more stable investment because it guarantees a regular dividend that is not directly fixed to the market, like the common stock. That means whether or not the company grows, you would receive the same amount of dividends.
Preferred stockholders have more priority and a greater claim on the company’s assets and earnings than common stockholders. Even though preferred stockholders are paid before stockholders, they are paid after bondholders. Preferred stockholders also do not have voting rights. They can only vote on certain issues such as if the company wants to merge, liquidate assets, or issue more bonds or preferred stocks.
There are 4 types of preferred stocks:
1) Cumulative preferred stock – Guarantees an investor that if one or more dividends are not paid, the missed dividends will be accumulated. All the dividends must be paid in full before any common stock dividends can be distributed.
2) Noncumulative preferred stock – Any dividends missed are lost to the stockholder.
3) Participating preferred stock – You receive extra dividends when a company does well.
4) Convertible preferred stock – Allows you to convert a certain number of preferred shares to common shares.
Should you buy common stocks or preferred stocks?
Preferred stocks are less volatile than common stocks but they typically have less potential for profit. Common stocks are riskier but have the potential to return higher yields through capital growth over time. Whether you should buy common stocks or preferred stocks depends on your risk tolerance. How much risk would you undertake to in order to capture higher returns?
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