Here’s what you need to know about these two popular investment styles.
What is preferred stock?
Preferred stock is a type of stock that offers different rights to shareholders than common stock. Preferred stock holders receive regular dividends and are repaid first in the event of a bankruptcy or merger. Companies typically issue more common shares than preferred ones, which are generally prized by investors looking for a steady income.
Stock represents a percentage of ownership in a company, the value of which is determined by the market and the volume of which is determined and issued by the company.
At the most basic level, there are two kinds of stock: preferred and common. Preferred stock is rarer than common stock, generally comprising a small proportion of all shares. It’s often more expensive, and can come with a minimum purchase amount.
The main difference is in how investors extract value. When a company pays a dividend, it must issue them to preferred stock holders first before paying anything to common stock holders, who sometimes don’t get paid a dividend at all. Holders of preferred shares are also repaid first in the event that the company has to liquidate its assets, such as in a merger or acquisition or a “solvency event” like bankruptcy.
However, unlike common stock, they don’t usually come with voting rights. In that sense, preferred stock is a way to entice early investors without jeopardizing the mission of the company’s owners.
Some preferred stocks have additional benefits, like:
- Convertibility: convertible preferred stock can be exchanged for common stock, but not vice versa.
- Anti-dilution: when a company issues more shares, the price of an individual share falls. Anti-dilutive preferred stock allows investors to receive more shares of a stock than he original paid for in the event that his are worth less as a result of a dilution.
- Callability: the shareholder has the right to redeem her shares for a predetermined amount called a call price.
Small-time investors might consider a CD instead. Check out Bankrate’s list of the best ones.
Preferred stock example
Corporation X is a new startup looking for investors. It issues 10,000 shares, of which 1,000 are preferred shares. Investor Y purchases 200 preferred shares. She can now sit tight while dividends start rolling in, netting herself a reliable income as long as the company is profitable.