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Preferred Stock vs Common Stock: The Difference Explained

Preferred Stock vs Common Stock: The Difference Explained

Common stock and preferred stock are fundamentally different investments. Common stock represents company ownership, whereas preferred stock is closer to a bond than it is to common stock. In this guide, we will first quickly cover the definitions of each both common stock and preferred stock and then dive into a comparison between the two with real life examples.

Common Stock Definition

Common stock is the type of stock that most investors purchase. It is the stock that is most commonly traded every day on the open market. The ticker symbols frequently seen on news programs or websites almost always reflect common stock prices.

Common stock represents ownership in a company. Holding shares of a stock gives shareholders voting rights (which are used in referendums and to elect the board of directors). Common shareholders may or may not receive a dividend – the board of directors typically sets the dividend for the company. Growth companies are not expected to pay a dividend at all, whereas mature companies with steady growth typically raise their dividends over time. Neither type of company guarantees their dividend to common stock shareholders.

The purpose of owning common stock is to own a piece of a company. Return for common stockholders is tied directly to the company’s performance.

Preferred Stock Definition

Preferred stock is a special type of stock that operates in a very different manner from common stock. Preferred stock typically has predetermined dividends which are paid at predetermined dates. Typically, a preferred stock will pay out a certain amount of money every year that does not change from the date of the company’s issue. Once these shares are issued, they are up for trading in the open market. Preferred shares may gain or lose some value, but do not fluctuate nearly as much as common stock.

Unlike common stock shareholders, preferred shareholders are always supposed to get a dividend. A company’s board may elect to skip a dividend payment or cancel a dividend altogether for common stock shareholders, but preferred shareholders cannot have their dividend skipped unless the company truly does not have any money to pay out.

Some preferred stock is considered cumulative. A shareholder of cumulative preferred stock is able to receive back-pay on missed dividends. In other words, if preferred stock is supposed to pay $3 a quarter and the company misses two quarters of payments, the shareholder will receive $9 on the date of the third dividend payment (assuming the company can afford it by that time).

The Three Common Differences Between Preferred and Common Stock

Now that we know the definitions of common and preferred stock, let’s discuss the three primary differences between these stock types: compensation, voting rights, and bankruptcy. For the purpose of this comparison, we will compare Bank of America Corporation’s common stock (NYSE: BAC) to its Series-L preferred stock (NYSE: BACPRL)

Common vs Preferred Stock: Compensation

The primary difference between common stock and preferred stock are the way its owners are compensated. Holders of preferred stock receive a predetermined dividend at a predetermined interval. By comparison, shareholders of common stock may or may not receive a dividend of a variable amount based on what the board of directors thinks the company will be able to pay.

Using the Bank of America as an example, consider that BACPRL (the preferred shares) pay out $72.50 a year to shareholders, split over four quarterly payments at predetermined dates. This represents over a 6% dividend based on current prices. There are no surprises here. By comparison, BAC (the common shares) only pay out $.01 every quarter (a yield of less than .5%). BAC used to pay out $.64 a quarter before the mortgage crash in 2008; after the crash, BAC skipped a dividend payment and then cut the dividend to just $.01.

When viewing the comparison in this manner, one may begin to wonder why anyone buys common stock at all. Understand that this represents a scenario when the company the common stock represents does poorly. When the company does well, the dividend for common stockholders can be raised. Mature companies that perform well try to raise the dividend on an annual basis for common stockholders. Preferred shareholders tend to receive the same dividend without any payment hikes. This makes preferred shares almost like a high-yield bond.

As a side note, you may be wondering why anyone would buy preferred shares instead of bonds. Preferred shares tend to pay out higher yields than most bonds, which is countered by a higher element of risk. Many preferred shares often contain a clause that if the common stock does exceptionally well, that the issuing company may convert the preferred shares into common stock at a certain profit for the preferred stock shareholder. As an example, BACPRL has a clause in its prospectus that allows Bank of America to convert BACPRL to BAC at a 30% premium after July 30th, 2013.

In the long run, common stock yields tend to outpace the yields provided by preferred shares. If the company that the common stock belongs to does exceptionally well, its yields will significantly outpace the yield provided by the preferred shares. On the other hand, if the company does poorly (but is not bankrupt, such as in the case of Bank of America), preferred shares may provide a reliable yield while common stock holders may lose money.

Common vs Preferred Stock: Voting Rights

The difference in voting rights between common and preferred stock shareholders is straight-forward: common shareholders get voting rights whereas preferred shareholders do not. Companies typically have an annual shareholder meeting where shareholders can vote on certain issues. These votes are often non-binding, but give the board and company management an idea of what the shareholders want from management.

Common stock shareholders also elect the board of the directors of the company. The board is responsible for hiring executives (including the CEO), setting dividend or share buyback plans, and approving acquisitions and mergers. In a way, common stock shareholders are like members of a republic, where they elect leaders to rule in their stead.

The importance of voting rights is highly dependent on wealth. Each share of common stock held represents one vote. A rich individual or investment group highly invested in a single company might own 10% of all common stock. The average investor might own .0001% of a company’s stock. The vote of the shareholder that owns 10% of common stock will be weighted as 10,000 times more important than the individual owning .0001%. As a result, voting rights are not that big of a deal for small shareholders; this difference between common and preferred stock is negligible for most investors.

Common vs Preferred Stock: Bankruptcy

In the case of bankruptcy, preferred shareholders are given preference over common stock shareholders in getting paid back for their initial investment. As an example, imagine a manufacturing company went out of business, but still had billions of dollars worth of equipment and factories. After selling off these buildings and equipment, the company still might have billions of dollars left over even after all creditors are paid.

After creditors are paid, any outstanding company bonds are then paid. After bonds are paid, if there is still money left, preferred shareholders are paid out the value of their initial note (as money allows). If there is any money leftover after all three parties in this example are paid out (unlikely), then common stock shareholders will split the remaining sum.

This caveat helps lower the risk of owning preferred stock over common stock. It is an important one as companies often issue preferred stock when they need capital but are not in a position to attract investors. Let’s once again consider Bank of America as an example. Near the peak of their crisis, Bank of America sold $5 billion dollars worth of a special class of preferred stock to Warren Buffet and Berkshire Hathaway. Bank of America needed capital badly, and they were not in a position to issue new common stock as it already had lost most of its value due to the mortgage crisis.

Since preferred shareholders are given preference in being paid out in the case of bankruptcy (which seemed like a possibility at the time), it was easier for Bank of America to attract investment money for this type of stock. If preferred shareholders were not paid out ahead of common shareholders, it is unlikely that Buffet would have made that same deal (in spite of its very favorable terms).

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