Common vs. Preferred Stock: Key Differences Explained

Introduction to Common and Preferred Stock

Preferred and common stocks differ in two key respects: the priority of claims on company earnings and assets, and the nature and regularity of dividend payments. Understanding these differences is essential for investors deciding which type of equity best suits their financial goals.

Dividend Rights and Income Stability

First, preferred stockholders hold a greater claim to organizational earnings and assets. This is most apparent when a firm has excess funds and decides to distribute them as dividends. In such cases, preferred stockholders must be paid before common stockholders. This priority becomes especially critical if the organization becomes insolvent: if it comes to liquidation and all bondholders and creditors have been paid, common stockholders receive nothing unless all preferred shareholders have first received their due (Bratton & Wachter, 2013).

Second, preferred stock dividends differ from — and are generally higher than — common stock dividends. When purchasing preferred stock, investors know when a dividend is to be expected, since these are paid out on a regular schedule. This is not necessarily the case with common stock, as the company's board of directors retains the authority to decide whether to pay common dividends at all. Because of this characteristic, preferred stocks typically do not fluctuate as frequently as common stocks and can at times be categorized as fixed-income securities. Adding to their fixed-income nature, preferred dividends are generally guaranteed: if the organization misses one, it must pay it before disbursing any further dividends on either class of stock (Bratton & Wachter, 2013).

Voting Rights, Appreciation, and Callability

There are situations, however, in which common stockholders hold greater rights than preferred stockholders. Most notably, common stockholders generally have voting rights with respect to board decisions and corporate policy, while preferred stockholders typically do not. While preferred stocks carry the advantage of lower volatility relative to common stocks, preferred stockholders are at a relative disadvantage when it comes to potential capital appreciation. Corporate achievements — such as a major acquisition or innovation — or other events that cause common stock prices to rise sharply may have a comparatively smaller impact on preferred stock values. As a result, growth-oriented investors may find preferred stocks less attractive, while income investors typically favor the stronger fixed-income position that preferred stocks offer (Schowitz & Albrecht, 2014).

Much preferred stock is also redeemable or repurchasable by the issuing company, usually after a specified date — that is, it is callable. Unlike common shareholders, preferred stockholders may therefore be required to surrender their investment before they wish to do so, potentially preventing them from realizing some of the income they had anticipated from their holdings (Schowitz & Albrecht, 2014).

Investor Reaction to New Common Stock Issuance

When a new constituent is added to a stock index, its market value, earnings, and other attributes are simply added to the corresponding index aggregates. Current investors, however, have no claim to those new earnings; they must purchase stock in the new company — either by diluting their existing holdings or by committing new capital — to participate in any additional earnings. A commonly made mistake is assuming that investor dividends and earnings can grow in proportion to, or even beyond, overall gross domestic product (GDP) growth in perpetuity. Even granting that assumption, it remains virtually a truism that aggregate corporate income must, over the long run, keep pace with the overall economy — otherwise, earnings would eventually surpass the entire economy's size or decline to insignificance. However, much of this earnings growth does not accrue to current shareholders. A large share of economic expansion arises from the creation of new businesses. Some commentators suggest that new businesses account for more than 50% of GDP growth in the United States, while in some rapidly growing economies, new companies may account for the majority of total economic growth (Schowitz & Albrecht, 2014).

Because current shareholders are not entitled to the earnings of newly formed enterprises until they invest in them — either through dilution of existing holdings or through new capital — a persistent slippage, or continual dilution, can be observed between investors' earnings per share (EPS) and aggregate earnings growth (Schowitz & Albrecht, 2014).

References

Bratton, W. W., & Wachter, M. L. (2013). A theory of preferred stock. Faculty Scholarship, Paper 1391.

Casson, P., & McKenzie, G. (2007). A comparison of measures of earnings per share. The European Journal of Finance, 13(3), 283–298.

Schowitz, P., & Albrecht, M. (2014). How dilution and share buybacks impact equity returns. J.P. Morgan Asset Management.