Businesses continually require money to grow which they can obtain by issuing shares of two types. Preferred stock and common stock. Generally, when we refer to stocks, it means a common stock that allows shareholders to earn dividends. These stocks can be sold when the selling price significantly surpasses the purchase price. Besides, decision-making processes are open to voting by common shareholders. On the other hand, preferred stocks are similar to bonds according to which the company has to pay a set dollar amount to shareholders. Although preferred shareholders do not have voting rights, they have secured preference over common shareholders.
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Types and Differences
Common Stock and Its Types
Common stocks technically ensure the shareholder’s partial ownership of the company. In this case, the investors have the legal right to vote and help in the selection of the company’s board of directors. Moreover, they hold importance in significant business decisions. Companies declare dividends on their shares which the common shareholders have the right to receive.
Some established companies hold the leadership position in their respective industry which allows them to obtain stable dividend records and earnings. These blue-chip companies are appealing to investors because they have a reputation for regular dividend payouts and increasing profits.
Moreover, shareholders are inclined towards such blue-chip stocks because they have sufficient earnings to overcome economic disruptions.
Income stocks refer to higher-than-average dividend payouts that apply to companies that are at the maturity stage of the product life cycle. Prices on income stocks tend to not rise as much as blue-chip stocks since they are on the maturity stage and not at a growing stage like the blue-chip stocks.
This, however, does not mean that companies with income stocks are about to run out of business. It’s just that they lean towards paying higher dividends while maintaining stable earnings and cash flow.
At a certain stage companies are required to prolong a high rate of growth which calls for the issue of growth stocks. Generally, these companies do not pay dividends and maintain a high price/earnings (P/E) ratio. The favorable P/E ratio builds interest in investors to purchase the growth stocks at higher prices to mainly increase their potential capital.
Value stocks on the other hand have a lower P/E ratio in comparison to growth stocks. They are usually purchased by patient investors who are willing to focus on longer time horizons while waiting for the earnings to increase. There is an increase in the number of value stocks at the end of an economic expansion period. Which is when investors do not expect immediate growth of specific companies and are willing to purchase such value stocks.
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Preferred Stock and Its Types
Preferred stock represents a share of ownership in a company, which has a priority over common stocks. Unlike common stocks, preferred stocks pay fixed dividends at regular intervals. They are usually higher than common stocks and can be recalled upon by companies before they mature via issue price payment.
As the name suggests, convertible preferred stocks come with an option to be converted into common stocks in the future depending on the following:
- A suggested vote by the company’s Board of Directors
- Conversion based on the rise in the price of the common stock in comparison to the net present value of your preferred stock
- Automatic conversion on a pre-agreed date
Cumulative stocks are highly beneficial to companies during rough times since they allow the suspension of dividend payments based on the fact that they will be paid as soon as the company is doing better.
A perpetual preferred stock refers to a fixed dividend payment to investors for the whole duration of the company’s existence. Besides, there is not a predetermined date on which the investors will get back the capital they invested.
According to redeemable preferred stocks, the company can retrieve the stock at any given time after an established date, which is not usually for a few years. These stocks have a comparatively higher rate since companies are willing to bear the redemption risk (drop in interest rate).
4 Major Differences between Common Stock and Preferred Stock
1.Preference of Liquidation
Preferred stock has priority over common stock. In the dissolution of a company, the preferred investors or stakeholders are paid a certain amount of money before the common stock stakeholders. This is one of the major debatable features of preferred stocks. However, if the said company has high proceeds to cover the payments of both the preferred and common holders. The liquidation preference becomes invalid.
In the case of preferred stocks, the dividends are already agreed upon and need to be paid at orderly intervals. While the common stock dividends are paid based on the profitability of the company.
Common stock shareholders have the right to vote and participate in the selection of the board of directors of the company. Along with the decision making processes that influence transactions. Preferred stock shareholders, however, do not possess such voting rights.
Common stock shareholders are impacted by both the profit and loss of the business and have to pay the specified dividends to the investors irrespective of the position of the business. On the other hand, preferred stocks are not affected by the performance of the company. As preferred shareholders are entitled to receive a fixed rate of return.
The total share of a company includes both common stocks and preferred stocks, which makes them partial owners of the company. Most investors focus on long-term growth which is why they resort to stocks as investments. Common stocks would be ideal for such investors because common stocks have unlimited upside potential.
However, if an investor’s focus is on primary income, they should invest in a preferred stock based on the reliability of dividends. Both the common stock and preferred stock have their benefits and drawbacks. Therefore investors should select the one that tailors to their specific goals.
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