Stock Market Guide: Difference Between Preferred and Common Stocks

Each person investing in the financial market has a specific goal. Many do so in the search for greater profitability and others to diversify their businesses. There are even those who wish to have a piece of a business that they find profitable.

By buying stocks of a certain company, the investor becomes its partner. However, the type of stock purchased will determine its benefits, which go beyond profit sharing.

When deciding to acquire a stock, the investor will have the options between a preferred or common stock. While both give shareholders ownership in a company, they come with different shareholder rights.

Characteristics of common stocks

The main characteristic of common stocks, also known as ordinary stocks, is that they give the shareholder the right to vote at shareholders’ meetings, which usually decides the next steps of a company’s management.

Because they have this feature, many investors who are interested in long-term strategic changes find this kind of stock more favourable.

However, for the small investor, this right is very limited as their vote can be quite insignificant against large investors.

Another advantage: tag along

Another positive feature of common stocks is that they grant their shareholders the right known as an 80% tag along. This is a benefit granted by companies if their control is sold or transferred to third parties.

In theory, that means that investors who own common stocks have this kind of insurance, which grants them the right to sell their stocks to the buyer for 80% of the price the buyer offered to the controlling shareholder of the company.

Know your rights as an investor

Common stocks holders have the right to receive fluctuating dividends depending on the company’s performance, but only after the preferred stock shareholders.

They are also entitled to their share of the residual economic value of the company, in case of winding-up or insolvency. However, they are the last in line after bondholders and preferred shareholders to receive the proceeds.

Just one obligation

The only obligation a common stock owner has is to pay the price of the share to the company when it’s issued.

Despite being a shareholder and voting, the holder of ordinary shares is not responsible for the company’s debts.

Characteristics of preferred stocks

Preferred stocks, unlike common stocks, do not entitle shareholders to vote at meetings and participate in the company’s decision-making process. However, shareholders have preferences in some events to compensate for their lack of voting power.

For example:

  • priority to receive fixed or minimum dividends
  • priority in capital repayment in case of winding-up or liquidation
  • accumulation of the two preferences above
  • higher fixed-income payments than common stocks

But the most striking feature is undoubtedly the possibility to receive profits from the company before shareholders who hold common shares in that business.

Preferred stocks also offer the option of participatory shares that include a guaranteed dividend payment as well as payment of additional dividends, if the company meets certain performance goals.

In addition, preferred stocks are generally more liquid than common shares. They are easier to trade and are usually priced better than common shares.

Cumulative and non-cumulative dividends

Basically, dividends are distributions of the company’s profits to shareholders. They are paid to preference shareholders prior to common owners receiving dividends.  Cumulative dividends are calculated for each fiscal year and the right to receive them is carried forward until paid.

With non-cumulative dividends, if the board of directors doesn’t declare them in the fiscal year in question, the right to receive them is extinguished.

Companies prefer to issue preferred stocks

Normally, companies that have not yet reached a level of success will offer preferred stocks first. This is a simple way of raising the capital they need to grow.

Preferred stocks also offer companies financial flexibility. As dividends can be deferred for some time, it can help fix the cash flow.

Conclusion

Common shares are highly targeted by those who wish to take relevant positions in the controls of public companies. In addition, because they have the benefit of tag along. They arouse a great deal of interest among investors who may not feel like their investments are secure due to the future of a company. In any case, one must always study each company separately and its conjuncture before deciding whether or not to invest in one of its common shares.

Otherwise, investors looking for relatively safe returns shouldn’t overlook preferred stocks. Many strong companies in stable industries issue preferred stocks that pay dividends above grade bonds and common stocks.

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