Common versus Preferred Stock

by | Dec 16, 2015 | Educational | 0 comments

When you hear someone talking about investing in stocks, he or she is usually referring to investing in common stocks. However, companies offer two classes of stock: common and preferred. While most investors are pretty knowledgeable about common stocks, they are not well-informed when it comes to preferred stocks. The main similarity between common stocks and preferred stocks is that when you purchase either one, you become a partial owner because they both represent a form of equity. However, there are more differences between them than similarities.

When you own a common share of a company, you usually have one vote per share that entitles you to participate in the election of the board of directors. As an owner of a preferred share, you usually do not have any voting rights; however, you can convert it into a common share. Common stock shares also enjoy preemptive rights that allow you to maintain a certain ownership percentage in a company. For example, if you own 100 shares out of 1,000, your ownership share is 10 percent. If the company issues an additional 1,000 shares, the preemptive rights give you the right, but not the obligation, to purchase an additional 100 shares so that you can maintain your 10 percent ownership stake in the company.

When it comes to dividends, common shareholders do not know the amount they will receive in advance, whereas preferred shareholders know the exact amount because their dividends are fixed. Also, the dividends on preferred stocks are usually higher than the dividends on common stocks. However, the dividends on common shares are likely to increase as the company grows, whereas the dividends on preferred shares stay the same.

Because the dividends on preferred shares are fixed, the prices of preferred shares behave more like the prices of bonds than the prices of common shares. Bond prices are sensitive to changes in interest rates in such a way that when interest rates rise, bond prices fall and vice versa. The same principle applies to preferred shares.

Preferred shares can be classified into cumulative or non-cumulative. Cumulative preferred stocks accumulate unpaid dividends which must be paid out to preferred shareholders before any dividends are paid to common shareholders. For example, if the company promised preferred stock shareholders a 5% dividend on a par value of $100, every year a $5 dividend is due. If in Year 1, the company doesn’t pay it, for whatever reason, in Year 2 it must pay the $5 dividend in arrears plus the current $5 dividend to preferred shareholders before common shareholders see a dime.

In the event that a company is liquidated, the preferred stockholders get preferential treatment because they receive their money before common stockholders. This feature allows the company to raise capital from venture capitalists before it goes public because most venture capital deals are structured as preferred stock. Under this kind of arrangement, the founders and employees receive common stock, and venture capitalists receive preferred stock, which provides them with a liquidity preference that serves as a margin of safety. The liquidity preference determines who gets what in the event of insolvency. The liquidity preference could be anything times X. For example, a 2X liquidation preference means that the preferred shareholders receive two times the original investment before the common shareholders receive anything.

Outside of venture capital, issuing preferred stocks is just another way of financing. Sometimes, companies do not want to issue more common stock or are unable to get more debt financing because they might already carry too much debt. In this case, using preferred shares as an alternative way of financing might be beneficial. Preferred shares do not carry any voting rights and at the same time, are more lenient with respect to the payment on the cost of capital because the company can defer paying dividends into the future if it needs to without a penalty. Dividends do not become a liability until they are declared; however, this is not the case with traditional debt where missing a payment would put the company’s future in jeopardy.

The majority of the investment public mainly invests in common stock; however, preferred stocks appeal to certain groups such as retirees and institutions. Because preferred stocks offer current income and are less volatile than common stocks, they are appealing to retirees. Another group of investors that often chooses preferred stocks is institutions. They are drawn to them because the IRS provides them with dividends-received deduction. Under this deduction, institutions are allowed to deduct 70 percent of dividends if they own less than 20 percent of the dividend-paying company, 80 percent if they own between 20 and 80 percent of the dividend-paying company, and 100 percent if they own more than 80 percent of the dividend-paying company. You might ask why institutions get this break when individual investors must pay taxes on these dividends. Many of you know that the disadvantage of having a corporate structure is double taxation as companies have to pay taxes on their earnings and shareholders have to pay taxes on distributed earnings. If the preferred shareholder is another corporation that also happens to pay its own dividends, this would mean triple taxation. That’s why the IRS gives institutions dividends-received deduction.

To sum it up, both common and preferred stocks allow you to participate in the equity stake of companies; however, common stocks are more popular because they allow more potential for future growth, while preferred stocks offer current income through fixed dividends but limited future growth potential.

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About Mariusz Skonieczny

Mariusz Skonieczny is the founder of Classic Value Investors.