Common Stock Versus Preferred Stock

The two classes of stock issued by publicly traded companies are common stock and preferred stock. When an investor discusses stock, he almost always is talking about common stock. Common stock is what the name implies, the most common class of stock. Common stock represents ownership in a company and confers voting rights to guide the path of that company. Preferred stock, as the name implies, offers better income potential and a higher degree of protection than common stock if the company goes bankrupt. However, preferred stock does not carry voting rights.

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Significance

Common and preferred shares are issued to raise capital for a given company. However, after the initial public offering of common stock, secondary issues of common stock dilute the value of the original shares. For example, if XYZ issues 1,000,000 shares of stock and Ike the Investor owns 50,000 of them, Ike owns 5 percent of the company. If XYZ then issues another 1,000,000 shares, Ike's 50,000 shares now only represent 2.5 percent of the company. To avoid dilution in most cases, companies may issue preferred stock. Preferred shares (unless they are convertible to common stock) don't have the dilutive effect of a secondary common stock offering. Investors are enticed to buy preferred shares (thus raising working capital for the company) by offers of dividends not available to common stockholders, and other preferential benefits.

Function

Common stock represents ownership in a company. Preferred stock is actually closer to debt equity in a company. Preferred stockholders generally receive dividends agreed to in advance, and are the first stockholders to receive assets in the company when the company goes bankrupt. In other words, the company's creditors are paid first, then any remaining assets go to the preferred stockholders before any money goes to common stockholders. Also, before a dividend can be declared for common stockholders, all dividend requirements for preferred stockholders must be met.

Time Frame

Occasionally, a company will issue preferred stock that is convertible to common stock, and this convertible preferred stock usually has a time provision attached to it. In other words, it is only preferred stock for a predetermined period before it automatically converts to common stock, or it carries a provision allowing the preferred stockholder to convert to common stock at the stockholder's discretion. Often, a preferred share may be convertible into more than one share of common stock, so it is possible for an arbitrage possibility to exist. For example, if XYZ Preferred stock is convertible into two shares of common stock, and XYZ Preferred is trading at $10 per share while the common is trading at $5.50 per share, that $10 preferred share could be converted into two shares of common stock worth $11.

Size

The size of the common stock equity market in the U.S is many trillions of dollars. By contrast, the size of the preferred stock market can be as little as 1 percent of the overall market.

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Warning

While preferred shares offer a higher level of protection than common shares, that doesn't mean they don't carry risk. All stock carries risk, and when a company goes bankrupt, most of the company's creditors don't even recoup their losses. This leaves nothing for either preferred or common stockholders.