Preferred Stock vs. Common Stock

Definition

Preferred stock and common stock are two main types of equity securities that represent ownership in a corporation. Preferred stock typically provides shareholders with fixed dividends and a higher claim on assets during liquidation, while common stock usually offers voting rights and the potential for capital appreciation but comes with greater risk. Understanding the differences in these securities helps in evaluating the financial structure and investment potential of a company.

5 Must Know Facts For Your Next Test

1. Preferred stockholders generally receive fixed dividend payments before any dividends are paid to common stockholders.
2. In the event of a company's liquidation, preferred stockholders have priority over common stockholders when it comes to asset distribution.
3. Common stockholders have voting rights, allowing them to influence corporate governance and decisions, while preferred stockholders usually do not.
4. Preferred stock may be convertible into common stock, giving investors the option to exchange their shares under certain conditions.
5. The market price of common stock is often more volatile compared to preferred stock due to its link with company performance and growth potential.

Review Questions

• What are the primary differences between preferred stock and common stock in terms of dividend payments and claims on assets?
  • The primary difference between preferred stock and common stock lies in dividend payments and claims on assets. Preferred stock typically offers fixed dividend payments that must be paid before any dividends are distributed to common stockholders. Additionally, in the event of liquidation, preferred stockholders have a higher claim on the company's assets compared to common stockholders, who only receive residual claims after all debts and preferred shares have been satisfied.
• How do voting rights differ between preferred and common stock, and what impact does this have on shareholder influence?
  • Voting rights significantly differ between preferred and common stock; common stockholders possess voting rights that allow them to participate in key corporate decisions such as electing the board of directors. In contrast, preferred stockholders typically do not have voting rights, limiting their ability to influence management decisions. This difference can impact the level of control that shareholders exert over corporate governance, with common shareholders being more actively involved in shaping company policies.
• Evaluate how market perceptions of risk can affect the pricing and demand for preferred versus common stock.
  • Market perceptions of risk play a crucial role in influencing the pricing and demand for preferred versus common stock. Preferred stock is generally viewed as less risky due to its fixed dividends and priority during liquidation, making it attractive during economic downturns or when companies face financial uncertainty. As a result, demand for preferred shares may increase during such times, often leading to higher prices. On the other hand, common stocks are more susceptible to market fluctuations driven by company performance expectations, potentially resulting in higher volatility and wider price swings. Investors may shift their preferences based on risk appetite and market conditions.

Related terms

Dividends: Payments made by a corporation to its shareholders, typically derived from profits, that can be in cash or additional shares.

Liquidation Preference: The order of priority in which claims against a company's assets are settled in the event of liquidation, often favoring preferred stockholders over common stockholders.

Voting Rights: The rights of shareholders to vote on corporate matters, such as the election of board members and approval of major transactions, typically held by common stockholders.