Availability of sufficient funds is among the basic requirements for any business entity to start and/or continue its operations smoothly and fluently. In order to raise funds companies mostly use two basic methods; they either sell equity securities known as stocks or sell debt securities in the form of corporate bonds. These securities are sources of funds for companies who sell them and sources of continuous income for investors who buy them. The investors who buy such corporate securities may be individuals, firms, non-profit organizations, for-profit business entities or government institutions.
This article talks about the first type of security, the issuance of equity securities. It defines, explains and differentiates the two popular types of equity securities – common stock and preferred stock.
Common stock is the basic or primary type of equity that every company issues. Preferred stock can be regarded as the secondary type of equity. Many companies prefer to issue both types of equity. An advantage of issuing common and preferred stock in combination is that it attracts maximum number of investors because the two types of stock have their own distinct features, benefits and level of risk attached to them. Let’s briefly explain the both.
Definitions and meanings:
Common stock (also referred to as ordinary share capital) is the basic type of stock that forms and remains part of equity capital of a company for an indefinite period of time. The buyers of this stock hold ownership in the company based on their respective percentage of stock holding and are entitled to vote for the election of directors. The payment of dividend on this stock is however not guaranteed and also the percentage of dividend payment mostly fluctuates from period to period.
Preferred stock (also referred to as preferred share capital) is the second type of stock that companies often issue in combination with their common stock. The preferred stockholders are paid dividend at a fixed rate and are also given a priority over common stockholders regarding the payment of dividends. Therefore, this type of stock is considered to have properties of both shares and bonds. Preferred stock is further divided into two types based on the priority of dividend payment. These are cumulative preferred stock and non cumulative preferred stock.
As we have gotten the basic idea of what is a common stock and a preferred stock, let’s discuss some key points or characteristics that differentiate them from each other.
Difference between common stock and preferred stock:
The main difference between common stock and preferred stock has been explained below:
1. Economic value:
Common stocks are usual stocks, which offer a certain percentage of ownership of business to its holders. The common stock holders are entitled to receive dividends when business announces them. They are exposed to the risk of rise or fall in the market value of their investment as a result of economic fluctuations. Preferred stocks are sometimes known as a hybrid between common stocks and debt securities because it possesses the features of both of these financial instruments. Holders of this stocks also get dividend income but are preferred over common stockholders. Their investments are more stable than the common stockholders as prices of preferred stocks do not fluctuate majorly. The number of preferred stocks issued by a company are usually less than the number of common stocks.
2. Economic returns:
Common stocks are normal stocks of a business that attract dividend payments out of business’s profits and capital appreciation in market value for its holders. Preferred stocks also earn dividend payments for their investors, but these payments are usually kept higher than the common stockholder. However, market prices of preferred stocks remain in a closely packed band therefore this type of stock has very limited use for capital gains on investments.
Cumulative preferred stockholders get consistent dividend payments which can be delayed and carried forward if company ever faces cash flow problems. Common stockholders only get dividends when business has surplus cash because the payment of dividend to common stock is never guaranteed.
3. Risk potential:
The risk profile of common stock is higher than that of preferred stock. This is because the commercial activities of a business directly impact the price variations of common stocks. Additionally, there are many other factors like business reputation, brand image and investors behaviors etc. that augment to the determination of market price of common stock.
The prices of preferred stocks remain in a certain bracket which decrease the risk of capital depreciation for its holders.
4. Authority and voting right:
Preferred stocks, mostly, do not carry any voting rights until separately stated by the company. Therefore, preferred stockholders usually do not have any say in running of business activities and internal affairs of the company, especially the composition of board of directors that are appointed by shareholder’s votes. Common stocks almost always carry voting rights unless separately stated by the company and thus these stockholders have a prominent right to poll on agenda items in company’s general meetings.
In case of a bankruptcy, a company always prefers its bondholders and lenders who are repaid their money first. After settling all the debt liabilities, remaining cash is disbursed first to payback investments of preferred stockholders and then whatever remains goes to the common stockholders. If no cash funds are left after paying preferred stockholders, common stockholders do not get anything and their investments are lost.
Common stock versus preferred stock – tabular comparison
A tabular comparison of common stock and preferred stock is given below:
|Common stocks are normally invested for long term capital gains.
|Have more economic value in terms of investment security and short-term returns.
|Extract both dividend payments as well as capital appreciation of stock. Dividends are only paid when company has surplus funds.
|Earn more dividends than common stockholders, but are not suitable for capital appreciation. Dividend payments are constant but may be deferred.
|The risk profile of common stock is higher due to price fluctuations.
|The risk profile of preferred stocks is lower than common stocks due to lack of possibility of major price fluctuations.
|Authority and voting right
|Almost always carry voting rights.
|Do not normally carry voting right.
|Common stockholders are always paid in the end in case of a bankruptcy, if any money is left to the business.
|Preferred stockholders are paid before common stockholders in case of liquidation of the business.
Conclusion – common stock vs preferred stock:
Preferred stocks and common stocks both are securities that investors use to earn profits in stock markets. Every company issues common stocks, but preferred stocks are issued by some companies. Preferred stock may be a favorable financial instrument for both investors and the company. The investors who invest in preferred stock earn dividend income at a fixed rate while reducing the risk of loss of their principle investment and the company raises money without giving off any percentage of control which in turn do not alter the equity and debt proportions of the company.
Where the holders of common stock enjoy ownership rights and are entitled to have a say in company’s management by casting their vote for the election of directors, the holders of preferred stock enjoy a relatively less risky investment and are entitled to dividend income at a stable rate and on preferred basis. The investment decisions of potential investors majorly depends upon their risk appetite and earning preferences.