What is Preferred Stock?

Preferred stock is a class of equity ownership that has a more senior claim on the earnings and assets of a business than common stock. In the event of liquidation, the holders of preferred stock must be paid off before common stockholders, but after secured creditors. Preferred stock also pays a dividend; this payment is usually cumulative, so any delayed prior payments must also be paid before distributions can be made to the holders of common stock.

What is Common Stock?

Common stock is an ownership share in a corporation that allows its holders voting rights at shareholder meetings and the opportunity to receive dividends. If the corporation liquidates, then common shareholders receive their share of the proceeds of the liquidation after all creditors and preferred stockholders have been paid. This low level of liquidation preference can present a danger of lost funds when an investor owns the common stock of a business that is in financial difficulties. However, if a business is highly profitable, most of the benefits accrue to the common stockholders.

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Comparing Preferred Stock and Common Stock

There are a number of differences between preferred stock and common stock. They are as follows:

Voting rights. Shareholder voting rights are only given to the holders of common stock. These voting rights give shareholders the power to (for example) vote for company directors, issue more shares, and accept a takeover bid. In short, preferred shareholders have no control over the future of the company, while common shareholders can exercise some control over it.
Type of return. Preferred stock generally offers shareholders a fixed return, whereas the holders of common stock may or may not receive a dividend. Preferred stock is structured to be similar to a bond, with a fixed percentage payout from the face value of each share, though the company has no obligation to buy back the shares. Instead, the stated dividend is to be paid in perpetuity. Conversely, the holders of common stock only receive a dividend when the board of directors authorizes one - which it may not do if the cash flows of the business do not warrant such an expenditure.
Payout priority. The holders of preferred stock have a higher priority than common shareholders for a share of company funds. For example, if the company has not yet paid out preferred dividends, then the preferred shareholders would be entitled to be paid before the common shareholders can be paid their dividends. Also, in the event of a corporate liquidation, preferred shareholders will be paid before common shareholders.
Call feature. Some types of preferred stock have a call feature that gives the issuer the right to redeem them from shareholders after a certain minimum amount of time has passed, usually at a notable premium over the original price. Common stock does not have such a call feature.
Performance level. Common stock usually outperforms the returns generated by preferred shares, depending on the features associated with the preferred stock. This is because, if the issuer does well, the gains generated accrue to the benefit of the common shareholders, whereas the returns of preferred shareholders are limited to fixed dividend payments. However, when the issuer is not doing so well, the price of its common stock will substantially underperform the market.