Differences Between Common Stock and Preferred Stock
Updated: Sep 7, 2021
Businesses looking to raise money by selling stock may offer one of two different kinds: common stock or preferred stock. Both can be worthwhile investments, and you can find both types of stock on major exchanges.
The main difference between preferred and common stock is that preferred stock acts more like a bond with a set dividend and redemption price, while common stock dividends are less guaranteed and carry more risk of loss if a company fails, but there's far more potential for stock price appreciation.
Even though the name might suggest preferred stock is the better investment, the better choice depends on your objective: income now or long-term returns for the future. The table below shows the key differences between common and preferred stock.
Factor Common Stock Preferred Stock
Upside potential: Almost unlimited Limited to redemption value, except for convertible preferred
Downside risk: Can fall to $0 Can fall to $0 but is less likely to do so
Share price: More dramatic movements Less dramatic movements
More suitable for: Long-term growth investors High-yield dividend investors
Common stock gives investors an ownership stake in a company. Many companies exclusively issue common stock, and there's a lot more common stock selling on stock exchanges than preferred stock.
Investors holding common stock typically have the right to vote on the company's board of directors and to approve major corporate decisions, such as mergers (although some companies have a non-voting class of common shares).
The most attractive feature of common stock is that its value can rise dramatically over time as a company grows bigger and more profitable. This can create enormous returns for investors. For example, here's how much Apple (NASDAQ:AAPL) stock has gone up since going public:
A $1,000 investment in Apple's IPO would be worth almost $71,000 at recent prices. There have also been times when Apple shares have fallen sharply over shorter periods. This is part of the risk with common stock, which is far more volatile than preferred stock.
Common shareholders are last in line to get anything if a company fails. Lenders, suppliers, debt holders, and preferred stock owners are all ahead of shares of common stock. A common shareholder's willingness to take on the risk of losses if things go badly is offset by the potential for big returns if things go well.
Preferred stock often works more like a bond than common stock does. Preferred stock dividends are often much higher than dividends on common stock and fixed at a certain rate, while common dividends can change or even get cut entirely. Preferred stock also has a set redemption price that a company will eventually pay to redeem it. This redemption value, like a bond at maturity, limits how much investors are willing to pay for preferred shares.
The label "preferred" comes from three advantages of preferred stock:
Preferred stockholders are paid before common stockholders receive dividends.
Preferred shares have a higher dividend yield than common stockholders or bondholders usually receive (very compelling with low interest rates).
Preferred shares have a greater claim on being repaid than shares of common stock if a company goes bankrupt.
In other words, they're really "preferred" by investors looking for a more secure dividend and lower risk of losses.
The two main disadvantages with preferred stock are that they often have no voting rights and they have limited potential for capital gains. A company may issue more than one class of preferred shares. Each class can have a different dividend payment, a different redemption value, and a different redemption date.
Companies can also issue convertible preferred stock. In addition to the normal attributes of preferred stock, convertible preferred stock gives shareholders the right to convert preferred shares into common stock under certain circumstances.
Most investors buy stocks for long-term growth, so investing in common stock is usually the better choice because of the greater upside potential. The key is to consider your ability and willingness to hold the stock for many years and ride out volatility that can lead to losses if you sell in a downturn.
If your goal is generating income, preferred stock may be the type you're looking for, especially when interest rates are low. With fixed dividend payouts that are more reliable and usually higher than common stock dividends, they can be very attractive. Just remember that, while preferred stock is safer than common shares, it's still not as secure as a bond.
How to invest $1,000 right now
When an award-winning analyst team has an investing tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has quadrupled the market.
They just revealed what they believe are the ten best buys for investors right now… And while timing isn't everything, the history of their stock picks shows that it pays to get in early on their best ideas.