Similar to common stock, preferred stock grants you a percentage of ownership in a publicly-held company. And as a shareholder, you’ll earn dividends when the company turns a profit. But if you need to sell off your shares due to decreased performance or beef up your portfolio with more preferred stock to maximize profits, you’ll do so through a brokerage firm.
How Preferred Stock Differ from Common Stock
Although preferred stock share characteristics of both common stock and bonds, there are some key differences you should be mindful of.
Voting Rights
As a common stockholder, you’ll have voting rights in the entity you invest in (one vote per share). But preferred stocks do not afford you this opportunity. This is arguably the primary difference between the two types of shares.
To break it down even further, not having voting rights as a preferred stockholder means you won’t be able to cast a vote on anything involving the company’s operations, whether it involves corporate policies or another pressing matter. And you’ll be excluded from the official vote to elect members to serve on the board of directors.
Return of Investment
When you purchase shares of common stock, there’s a level of uncertainty that lingers as you may not earn a return or recoup your investment if the market takes a tumble. But with preferred stock, you can expect to receive your investment (at the minimum) if you hold the shares until they reach the date of maturity. Depending on the shares, that can be anywhere from 30 to 40 years.
Dividends
Preferred stocks pay dividends that are for a set amount of time, which is why they are said to exhibit similar characteristics to that of bonds. By contrast, common stock pays dividends whenever the board of directors signs off, but there are no guarantees with regards to when and if you’ll receive dividends. It depends on how the company performs.
You should also know that dividends paid on preferred stock tend to be higher than what common shareholders receive.
Another important note: if a company is unable to make dividend payments that were promised due to financial constraints, preferred stockholders are at the top of the list to be compensated when they are able to pay out dividends, followed by common shareholders.
Par Value
The par value of preferred stock is regulated by market conditions and interest rates. You can expect the value of these shares to increase as interest rates decrease, and vice-versa. However, the value of common stock is determined by supply and demand.
Taxation
Unlike common stock, which is taxed as unearned income at ordinary income rates, preferred stock dividends are taxed at capital gains rates. And in some instances, you may be exempt from capital gains taxes if you fall into the 10 or 15 percent tax bracket.
Liquidation
In the event of liquidation, preferred shareholders will have rights to the fledgling company’s assets before common shareholders will. Well, that’s after creditors and bondholders get their piece of the pie.
The payment amount is equivalent to the liquidation value of the preferred shares held, which is disclosed in the initial offering documents.
Some Important Considerations: Preferred Stock
When researching preferred stock, be mindful of the following:
- Debt or Equity
- Can the shares of preferred stock be called by the issuing company in exchange for the par value? How much time must pass before they’re able to do so?
- Can preferred shares be convertible into common shares?
- Are dividends on the preferred shares cumulative or noncumulative?
- Is the dividend rate fixed or adjustable?
- Is there a maturity date on the preferred shares or do they have a perpetual lifecycle?
Key Benefits of Preferred Stock
Leaning towards purchasing shares of preferred stock? It may not be such a bad idea as they are accompanied by several key benefits, including:
- A peace of mind knowing that preferred stock is analyzed and assigned a rating by a top agency, like Moody’s, Morningstar, or Standard & Poors, just to name a few. Consequently, you’ll have the reassurance that dividend payments will more than likely arrive on a consistent and timely basis.
- The ability to earn a guaranteed, consistent return on your money because of the stable nature of preferred shares, even in times of market turbulence. This is primarily attributed to the fact that preferred stock prices are closely correlated with interest rates.
Key Drawbacks of Preferred Stock
Unfortunately, there are a few drawbacks of preferred stock you must consider, including:
- The inability to possess voting rights as a shareholder. However, exceptions to the rule apply if a vote is being held that correlates to a unique circumstance outlined in the certificate of incorporation covenants.
- Limited earning potential since dividends are fixed beforehand and spikes in company earnings don’t necessarily equate to greater returns for shareholders.
- Minimal opportunity to diversify as a bulk of preferred shares is issued by those in the financial services, particularly, the banking industry.
The Bottom Line
The primary differences between preferred stock and common stock lie in voting rights, the way dividends are paid, and taxation. While preferred shareholders don’t have a say in company affairs, they do have seniority over common shareholders with regards to how and when dividends are paid. Plus, preferred shareholders enjoy generous tax breaks. And in the event a company liquidates, common shareholders stand to lose much more.
But keep in mind that preferred stock isn’t without disadvantages. If the board of directors pulls the plug on dividends, your earnings could suffer until they decide to resume payments. And you won’t be able to capitalize on a boost in company performance in the same manner as common shareholders.
So before taking the leap and investing, it’s best to consult with a reputable financial advisor for additional insight.
