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Potential investors who are looking to acquire a stake or ownership in a company can choose to purchase between common vs preferred shares. Companies typically issue and sell shares to raise funds for a variety of business initiatives. It is important to know and understand the individual characteristics and differences between common vs preferred shares before purchasing them.
What are Common Shares?
When someone refers to a share in a company, they are usually referring to common shares. Those who buy common shares will be essentially purchasing shares of ownership in a company. A holder of common stocks will receive voting rights, which increases proportionally with the more shares the holder owns.
Those who purchase common shares try to sell the share at a higher price than when they bought it in order to turn a profit. Sometimes, common shares will come with dividends that are paid out.
What are Preferred Shares?
Although preferred shares still include some features of common shares, they also share some features with a bond. As a refresher, the bond issuer borrows capital from the bondholder and makes fixed payments to them at a fixed interest rate for a specific period. Like bonds, preferred shares receive a fixed amount of income through a recurring dividend.
Additionally, preferred shares come with a par value, which is affected by interest rates. When the interest rates go up, the value of preferred shares declines. When the rates go down, the value of preferred shares increases. Similar to common shareholders, those who purchase preferred shares will still be buying shares of ownership in a company.
Differences: Common vs Preferred Shares
1. Company ownership
Holders of both common stock and preferred stock own a stake in the company.
2. Voting rights
Even though both common shareholders and preferred shareholders own a part of the company, only the common shareholders have voting rights. Preferred shareholders do not have voting rights. For example, if there were a vote on the new board of directors, common shareholders would have a say, whereas preferred shareholders would not be able to vote.
Although both shareholders can receive dividends, the payment of dividends differs in nature. For common shares, the dividends are variable and are paid out depending on how profitable the company is. As an example, Company A can pay out $2 in dividends in Quarter 1, but if they lose profitability in Quarter 2, they may choose to pay $0.
In contrast, preferred shareholders receive fixed dividends, so Company A would need to distribute a constant dividend of $2 at fixed intervals. The dividends for preferred shares are also cumulative, which means if they are missed one period, they will need to be paid back in the next.
Going back to the example, if Company A misses the $2 dividend for preferred shares in Quarter 2, they will need to pay $4 ($2 x 2) in Quarter 3.
4. Claim to earnings
When a company reports earnings, there is an order where investors are paid out. Usually, bondholders are paid out first, and common shareholders are paid out last. Because preferred shares are a combination of both bonds and common shares, preferred shareholders are paid out after the bond shareholders but before the common stockholders.
In the event that a company goes bankrupt, the preferred shareholders need to be paid first before common stockholders get anything.
Preferred shares can also be converted to a fixed number of common shares, but common shares cannot be converted to preferred shares.
Ultimately, both common and preferred shares are paid out of a company’s earnings. The returns of a common share are most commonly based on the increase or decrease of the share price, including an optional dividend paid out. In contrast, the returns on a preferred share are mainly based on its mandatory dividends.
Order of Claim to Earnings
Returns based on
Common Shares and Preferred Shares as an Investment
In terms of availability, common shares are a lot more available than preferred shares. Whether or not to buy common shares vs preferred shares ultimately comes down to the investor’s goals. Those who buy common shares are usually interested in the potential for higher profits, but with higher risk.
In comparison, those who buy preferred shares are usually interested in the regular dividend income with lower risk. Also, preferred stock may not be chosen by investors in an environment with rising interest rates, which lower the par value of the shares.
Thank you for reading CFI’s guide to Common vs Preferred Shares. To keep learning and advancing your career, the following resources will be helpful:
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