Those looking to invest in publicly traded companies can easily do so by purchasing shares of stock on the open market. Broadly speaking, stock grants the investor a fractional ownership stake in the company.
For many years, this model has been a source of funding that has helped companies grow. They use the money received from stock sales to invest in growth, pay off debt, or ramp up their research and development. While there are other sources of funding such as issuing bonds, stocks allow anyone who wants to invest an opportunity to earn a return.
However, there’s more than just one type of stock. While most investors buy and sell what is known as common stock, there’s also something called preferred stock. And each of these types can be further divided into classes.
This article will look at the differences between common and preferred stock. Each type has its own set of pros and cons and may be better for some investors, but not for others.
Common stock vs. preferred stock: How they compare
Not all stock is created equal. Common stock and preferred stock are the two types of stock that are most often issued by publicly traded companies and they each come with their own set of pros and cons. Here, we’ll look at each type and examine their strengths and weaknesses.
Common stock isn’t just common in name only; this type of stock is the one investors buy most often. It grants shareholders ownership rights and allows them to vote on important decisions such as electing the board of directors. They also get a say in certain policy decisions and management issues. Each share usually has one vote. Compared to preferred stock, common stock’s value tends to come more from its growth in share price over time rather than dividends.
Common stock has higher long-term growth potential but also has lower priority for dividends and a payout in the event of a liquidation. Lenders, suppliers, debtors, and preferred shareholders are all in line for a payout ahead of common stockholders. Common stock also has a greater chance of dropping to zero than preferred stock.
Common stock tends to be better suited to long-term investors.
- Grants voting rights
- No limit on how much the share price can grow
- Taxes on capital gains are deferred until stock is sold
- Greater price volatility
- May receive no dividends
- Dividends are paid out to preferred shares first, then common shares
- Lower priority than preferred shares to receive a payout in a liquidation
Preferred stock is a type of stock that pays shareholders a specified dividend and has priority over common stock for receiving dividends. Despite its name, preferred stock isn’t necessarily preferred by most investors (though it does have its benefits).
In many ways, preferred stock is like a bond. For example, the major source of return on a preferred stock is usually its dividend. They are also more likely to pay out a higher yield than common shares. Like bonds, preferred stock performs better when interest rates decline. And preferred stock has a par value, that is, a value it’s issued at and can typically be redeemed at, when the preferred shares mature.
Preferred stock also can be “called” (i.e., redeemed by the company) on a prespecified date. Thus, there is a possibility the call price could be higher than the price the investor paid. Another unique feature of some types of preferred stock is they can be converted into a fixed number of common shares; the reverse is not an option. This type of stock is called convertible preferred stock.
Preferred stock may be a better investment for short-term investors who can’t hold common stock long enough to overcome dips in the share price. This is because preferred stock tends to fluctuate a lot less, though it also has less potential for long-term growth than common stock.
- Receives a specified dividend that is often higher than common stock dividends
- Less chance of losing value
- Has priority over common stock for payout in a liquidation, as well as for receiving dividends
- Growth in share price is generally limited, up to the redemption value
- Often does not grant voting rights
How stock classes work
In most cases, there is only one class of stock when a company issues common stock. However, in some cases, companies may issue multiple share classes, often called Class A, Class B, and Class C shares, for example
Traditionally, Class A shares are publicly traded and come with one vote, just like any other type of common stock. Class B shares, on the other hand, may only be available to company owners and executives. In addition, they may have greater voting power than a single vote per share. Lastly, Class C shares tend to be much like Class A shares, but traditionally they have no voting rights.
Preferred stock can have different classes, too. In the case of preferred stock, different classes have different priorities in terms of dividends and a payout in a liquidation. But these classes still have priority over common shares. Like bonds, each series of preferred stock has its own dividend, call date and other terms.
If you look at a list of pros and cons for each type of stock, it might seem like preferred stock is better. However, while preferred stock has a higher priority for dividends and to receive a payout, that doesn’t necessarily mean preferred stock is better.
In general, common stock has greater long-term growth potential, meaning common stocks may be better suited for long-term investors. Thus, which type is better for you depends on your situation.