Common stocks and preferred stocks are the terms that you might encounter when you are trading.
But do you know what the meaning of these terms are? What are the pros and cons of each term?
You don’t have to worry anymore because today we’ll be discussing the difference between common stocks and preferred stocks.
Common stocks are a security that signifies ownership in a corporation. They are the type of stock that most traders are thinking of when they use the word “stock.” Stocks are partial ownership of a corporation, which are also known as “shares.”
In addition to that, common stocks allow stockholders to vote on corporate issues, which include the electing of board of directors and voting on corporate policy. Most of the time, stockholders receive one vote per share. They also receive a copy of the annual report of the company.
Many companies are giving dividend payouts to its stockholders. These dividend payouts can change based on how profitable the corporation is.
Since stocks are bought and sold during the day on a stock exchange, the price of a share of stock goes up and down depending on the demand. Therefore, corporate earnings, public relations announcements, and the health of the U.S. economy can affect stock prices.
There are two ways to make money from stocks: first you can earn from the dividend payments and second you can earn by selling it when the price of the stock increases. But you should keep in mind that you might lose your entire investment if the stock price drops.
Advantages and Disadvantages of Common Stocks
Common stocks have its advantages and disadvantages that you should know about.
- Yield Huge Gains – Common stocks have no limits to the amount of money that you will gain. There is always a risk of losing, but you are also certain that you’ll earn larger gains.
- Easy Buying and Selling Method – Since common stock is liquid, you can sell it any time you want. You can also buy more if you want to increase your stocks. One good thing about common stock is that it can be purchased at a fair amount.
- Legal Liabilities are Restricted – With common stocks, your liability to a corporation is limited. Whatever problems may come outside a stockholder’s financial investment, you will not be affected. The only people who would face the consequences are the one who run the corporation. Meanwhile, the only thing you need to worry about is the company’s health. As long as the corporation is earning and moving upward, your investment and financial future are safe.
- An Ideal Investment – In this type of financial vehicle, you’re only allowed to invest with limited charge. So whatever amount you invested in is mostly the amount of money you’ll lose in the event of liquidation.
- Lack of Control – Buying stocks from a corporation is a tricky situation. Your success will depend on whether or not the business has an excellent practices and strategies. Since you do not have the right to ask for a copy of a company’s business plan, you have to do your own research.
As a shareholder, you are also subject to the will of stockholders. You cannot join in the decision making process and you cannot propose a better way to do things. So if stockholders failed to do their jobs, you will go down with them.
That is why it is important that you perform due diligence before investing.
- Last One To Be Paid – One of the biggest downside of common stocks is that you are the last one to get paid. If a corporate liquidates, you would not get paid until those who are in the priority ladder get their shares.
- High Risk Investment – Risks are always linked with investing, but more of these are associated to common stocks. Their prices are volatile and fluctuating erratically. If you panic every time the price decreases and sell your stocks, you might end up losing a lot.
In addition to that, the value of the stocks can also change without warning, making it harder to evaluate their performance even if the corporation is doing well.
You should remember that the worst thing that could happen is for the company to go bankrupt. If this happens, you can lose all of your investments.
Preferred stock, on the other hand, is a share of ownership in a public company. Preferred stock has a combination of some qualities of a common stock and some of a bond.
Since preferred stock is a class of ownership in a corporation, it has a higher claim on its assets and earnings than common stock.
Meanwhile, the price of a share for both preferred and common stock are varies with the earnings of the company.
Just like common stock, preferred stocks pay a dividend. The only difference is that in preferred stocks you pay an agreed-upon dividend at regular intervals.
The preferred stock dividends are often higher than the common stock dividend.
Meanwhile, the dividend can be adjustable and vary with Libor, a benchmark interest rate. Dividend can also be a fixed amount that never varies.
In addition to that, corporations use preferred stocks to increase their capital for growth. They also use it to transfer corporate ownership to another company.
3 Types of Preferred Stock
- Cumulative Preferred Stock – It allows corporations to suspend dividend payments when bad times arise. However, in this tock they have to pay the missed dividend when the good times come. Companies must do this before they can make any dividend payments to common stockholders. Meanwhile, preferred stocks without this advantage are called non-cumulative stocks.
- Convertible Preferred Stock – It has the option of being changed into common stock in the future. There are three things to determine when this happens.
- First, when the Board of Directors of the company votes for a conversion.
- Second, you might decide to convert. You would only exercise this option if the price of the common stock is higher than the net present value of your preferred stock.
- Last, the stock might have automatically converted on a predetermined date.
- Redeemable Preferred Stock – This gives the corporation the right to redeem the stock at any time after a certain date. The option usually describes the price that the corporation will pay for the stock.
Advantages and Disadvantages of Preferred Stocks
Just like common stocks, preferred stocks have pros and cons. We listed some of them below.
- High Dividend Rates – The rates of dividend are generally higher than a comparably rated bond. Some high growth companies use their excess money to fund additional growth instead of paying dividend. However, mature companies who do not need money to fund their growth, they pay their investors with dividends.
- Graded by Rating Agencies – Like bonds, preferred stocks are evaluated and rated by the major credit rating agencies. They offer some degree of confidence in the constancy of dividend payments.
- Non-cyclical – Preferred stock prices are usually tied to interest rates. They are typically less vulnerable to investor psychology and they are also less volatile than common stocks.
- Lack of Voting Rights – Preferred stocks do not have the right to vote about the affairs of the company, such as selecting the board of directors of the corporation.
- Interest Rate Sensitivity – Just like bonds, preferred stocks are sensitive when it comes to interest changes. So if the interest rates go up, the market price of preferred stock will usually go down.
- Dividends Can Be Cut or Suspended – Dividends are not certain and can be eliminated any time by the board of directors of the corporation.
- Lack of Industry Diversification – Most of the preferred stock issuers today are in the banking industry. As a result, prices of most preferred stocks are abnormally sensitive to events that affect the financial sector.
It may seem hard to choose between common stocks and preferred stocks, but once you learn more about these financial vehicles it gets easier for you to choose.
The main difference of common stocks and preferred stocks is that common stock is a form of a piece of ownership in a corporation. Meanwhile, preferred stock is a share of ownership in a public corporation. However, in common stocks it allows stockholders the right to vote on corporate issue, while in preferred they do not allow it. Basically, they are the opposite of each other.
Moreover, you should also be aware about the pros and cons of both common stocks and preferred stocks. Therefore, it’ll be easier for you to choose what the best stock to choose is.
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