There are two general types of stocks: preferred stocks and common stocks. Both types of stocks are counted as contributed capital to a company, which is also part of the company’s equity. In today’s post, we will analyze the difference between the two types of stocks and see what are the advantages and disadvantages in holding either type of stock.
The difference between preferred stocks and common stocks lies in their rights. Preferred stocks, as its name suggests, are prioritized when it comes to dividend payments and liquidation situations. They have more benefits than common stocks:
Dividend Preference: Preferred stockholders receive dividends before common stockholders. Sometimes a cumulative provision can be part of the contract of a preferred stock, guaranteeing preferred stockholders previous unpaid dividends and current year dividends must be paid to them before they are paid to common stockholders.
Liquidation Preference: When a company goes bankrupt, all of its assets will be sold to pay back its creditors and shareholders. Once, the creditors are paid up, the shareholders get what’s left. Under such situations, a preferred stockholders will be paid in full before any common stockholders will be paid money.
Preferred stocks seem great, don’t they? Well, there are also some drawbacks that comes along with its secured returns.
First of all, preferred stocks receive a fixed dividend. Preferred stockholders receive a definite amount of benefit each year whilst common stockholders receive a variable amount. For common stockholders, if the company performs well, their dividends would increase, which in some cases can be a significant amount.
Second, preferred stocks are callable. It means that the company that issued these stocks can buy back from its shareholders anytime they want after a certain date. And the repurchase is mandatory. So, when the company believes its stocks are undervalued, it would buy back shares of the company from the market to push up the value of the shares. At that time, the preferred stockholders will be the ones missing their shares.
Third, the preferred stocks don’t give holders voting rights. This is a very important idea that makes preferred stocks kind of like corporate bonds. Preferred stockholders don’t participate in the management and decision making of the company. So they are basically lending money to the company and receiving interests from it. They get a fixed dividend every year, and some time in the future their share might be bought back buy the company, almost parallel to how the bonds work. The difference is, corporate bonds are much less risky, but on the other hand, preferred stockholders might receive the dividends for much longer than bondholders, as long as the company never buys back.
That concludes this week’s blog post. Next time, if you are trying to enter the stock market, think about what kind of stock you would like to hold. Are you more adventurous or are you looking for security? It’s always better to know more than know less.