Investor Jargon: Common Stock & Preferred Stock
A lot of investing-related language can be straight-up confusing. This can make investing seem scary and much more complex than it actually is. We’d rather investing be approachable, so we’re breaking down some of the common investing terms you might see or hear.
There are two main types of stock: common stock and preferred stock.
Aptly named, common stock is the most common type of stock. It’s likely what you think of when you hear the word stock. Public companies issue it and when you buy individual company stock from a stock exchange, you’re most likely buying common stock. Owning common stock in a company means you own a piece of the company itself.
How common stock works:
- Market price: The price for common stock can fluctuate with the stock market, investor sentiment, and the company’s profits and losses. (You can read more about how and why stock prices fluctuate here.)
- Voting rights: Shareholders with at least one full share of common stock have the right to vote on certain business decisions. (More on shareholder meetings and proxy voting here.)
- Dividends: If and when a company offers dividends, common stockholders are entitled to a dividend payment proportional to their ownership in the company—but that doesn’t mean the payment is guaranteed. Companies might pay dividends one quarter, but not the next; it’s an internal business decision. When dividends do happen, common stockholders are paid after preferred stockholders. If preferred stockholders don’t get paid, then common stockholders don’t get paid either. It’s also possible that the company may choose to only pay the preferred stock dividend.
- Liquidation: If a company has to sell all of its assets in the face of bankruptcy, common stockholders are entitled to some of it—but they’re last in line to get it. First, debtholders are paid, next preferred stockholders, and then common stockholders get their piece of the liquidated assets if there’s anything left.
Like common stock, preferred stock also represents ownership in a company. Unlike common stock, preferred stock is less… common. Not all companies issue it. There are a variety of reasons a company might choose to issue preferred stock when trying to raise capital. Issuing preferred stock, for example, doesn’t dilute existing shareholder voting control, and it can come at a lower cost to the company than issuing bonds (basically a piece of a company’s debt—low risk, but also low potential reward).
There might also be demand for it. Preferred stock can be attractive to some shareholders because it can provide a steady stream of income via dividend payments—which are paid before those to common stockholders. That’s part of why it’s called preferred.
How preferred stock works at a high-level:
- Market price: The price for preferred stock may fluctuate with interest rates and the company’s perceived credit worthiness (in other words, its ability to pay out dividends and debt).
- Voting rights: Owning preferred stock doesn’t grant you the right to vote in shareholder meetings. That said, a company may choose to give preferred stockholders votes in special circumstances.
- Dividends: Preferred stockholders are still entitled to dividends when a company chooses to offer them, but how they’re paid out is a little different—and can vary depending on the type of preferred stock (yep, there are different types). For simplicity’s sake, we’re going to focus on fixed-rate preferred stock. Dividends for fixed-rate preferred stock are paid at a (you guessed it) fixed rate that’s decided when the stock is issued. When you buy preferred stock, it’s issued with what’s called a par value—basically the value of each share of preferred stock. The par value does not change, is not at all related to market value, and it’s what dividend payments are based on. For example, if you buy a preferred stock that has a fixed 10% annual dividend and $100 par value, your potential quarterly dividend would be $2.50, adding up to $10 per year.
- Liquidation: Shareholders with preferred stock also have a claim in the case of liquidation—and their claim comes before that of common stockholders but after debtholders are paid.
While we’re not going to go too deep into the specific types of preferred stock here—that’ll be a future post—there’s one more we want to touch on. Some preferred stock is considered convertible. Owners of convertible preferred stock have the option to convert their preferred shares to common stock. How this works is a bit more complex than we’re going to get into here, but stay tuned.
Which is better?
One isn’t necessarily better than the other. It mostly depends on what a shareholder is looking for with their investment. Common stock can have a higher potential for growth than preferred stock, because the price for common stock can fluctuate with the perceived value of the company, while preferred stock’s price is affected by the perception of the company’s ability to pay dividends. That same fluctuation can also make common stock a riskier choice—because while the price can go up, it can also go down. It’s a trade-off: lower risk often comes with lower potential reward and higher reward often comes with higher risk.