Investing

Investing 101: Common Stock and Preferred Stock

(photo: iStockphoto)

Stock is stock, right? Not really. The two broad classifications — common stock and preferred stock — have important differences.

A preferred stockholder has a priority of claims against corporate assets in the event the company declares bankruptcy and reorganizes. As assets are liquidated, payments go first to creditors and bondholders; then preferred stockholders are paid and, last of all, common stockholders.

Dividends to preferred stockholders are different as well, often a contractual obligation. Common stock dividends are determined by the board of directors each year. These differences make preferred stock a sort of hybrid between a bond and a stock.

The common stockholder, on the other hand, is more likely to make profits from stock price appreciation than with preferred stock. Common stock moves as market conditions change, making common stock investing the default choice for many.

Common stock also pays dividends as declared each year, with quarterly ex-dividend date (the date when stockholders of record earn a dividend) and payment date (about one month later).

A second benefit is that as a common stockholder, an investor has the right to vote for members of the board, with each share representing one vote in most cases.

So while preferred stock is safer, it is not as likely to move in value based on market forces of supply and demand; common stock is not as safe, but it is potentially more profitable.

The comparison gets more complex when you consider the many different classifications of common stock:

Participating preferred entitles stockholders to increases in dividends when common stock dividends move higher.

Adjustable-rate preferred pays a variable dividend based on Treasury bill rates or rates of other securities.

Convertible preferred is stock that comes with a known conversion price. If that price is reached, the preferred can be traded for common stock.

And callable preferred stock (also called “redeemable”) comes with the provision that the issuer can repurchase shares at a specified price.

Which kind of stock should you buy?

It’s a matter of how much risk you can afford to take, versus how much profit potential you seek.

A very conservative investor will be drawn to the seniority of preferred stock over common stock, while recognizing that this safety comes with much lower profit potential. Essentially, preferred stockholders accept the guaranteed but relatively low-yield dividend.

A moderate investor will find common stock more appealing because of its potential for growth in value, and should be willing to live with market risk. The risks of common stock are mitigated by paying attention to the capital strength of the issuing company. Thus, common stock in a large cap company is going to be safer than that of a small cap company. However, the profit potential (and market risk) of the smaller company is going to be greater.

Picking the right company and the right kind of stock is determined by risk tolerance as well as your knowledge and experience. It is always a balancing act between two opposing forces: profit/loss potential, versus safety.

Michael C. Thomsett is author of over 60 books, including Winning with Stocks and Annual Reports 101 (both published by Amacom Books), and Getting Started in Stock Investing and Trading (John Wiley and Sons, scheduled for release in Fall, 2010). He lives in Nashville, Tennessee and writes full time.

Investing 101: Common Stock and Preferred Stock was provided by Minyanville.com.

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