Preferred vs. common stock: Pros, cons, and how to choose

Preferred stock formula

Formula:

Preferred stock price = Dividend / Discount rate

When valuing preferred stock, this formula helps investors assess the present value of the stock based on the fixed dividends and the expected return rate (discount rate). The dividend is usually fixed and determined when the stock is issued, while the discount rate reflects the required rate of return for investors.

Example:

If a preferred stock offers a USD 5 annual dividend and the expected return rate is 8%, the stock price would be calculated as:

Stock price = USD 5 / 0.08 = USD 62.50

This makes preferred stock relatively straightforward to evaluate since its fixed dividends provide predictable returns, making it an attractive option for those seeking steady income.

Advantages of preferred stock

Preferred stock comes with several benefits, particularly for investors seeking reliable income and lower risk.

Here are the main advantages:

Fixed dividends

One of the most appealing features of preferred stock is its predictable, fixed dividend payments- if there are distributions. This provides a steady income stream, which is especially valuable during market uncertainty. For investors looking for stability, this can be a significant advantage over common stock, where dividends are not guaranteed.

Higher claim in liquidation

If a company faces bankruptcy or liquidation, preferred stockholders are ahead of common stockholders when it comes to claiming the company's remaining assets. This gives preferred shareholders a layer of protection, particularly in more challenging economic conditions.

Lower price volatility

Preferred stock tends to be less volatile than common stock. Its price is less likely to fluctuate with day-to-day market movements, making it more appealing for risk-averse investors. The stability of the stock price is primarily due to the predictable nature of dividends, which anchor the stock's value.

Disadvantages of preferred stock

While preferred stock offers some benefits, it also has its downsides, especially compared to common stock.

Here are the key disadvantages:

Limited upside for capital appreciation

One of the most significant drawbacks of preferred stock is that it generally doesn't benefit from the same level of price growth as common stock. While common shareholders can see their stock prices rise significantly when the company performs well, preferred stock prices tend to remain stable, offering less potential for substantial capital gains.

No voting rights

Unlike common stockholders, preferred shareholders usually don't have voting rights. This means they have no say in important corporate decisions, such as electing the board of directors or approving major mergers. This can be an important downside for investors who want a voice in the company's future direction.

Callable feature

Many preferred stocks come with a callable feature, meaning the issuing company can repurchase or "call" the stock back at a predetermined price after a certain date. While this may seem like a minor issue, it limits long-term gains if the company calls back the stock just when its market value starts to rise.

What is common stock?

Common stock represents ownership in a company and offers investors the potential for long-term growth. It's the most familiar type of stock, giving shareholders the right to vote on major company decisions, such as electing board members or approving mergers.

When you own common stock, your return on investment is tied to the company's performance. If the company does well, the stock price can rise, allowing you to sell at a profit. Common stockholders may also receive dividends, although they're not guaranteed and depend on the company's profitability.

However, despite its growth potential, common stock comes with higher volatility. Stock prices can swing up and down based on market conditions, making it riskier than preferred stock. Additionally, in the event of bankruptcy, common shareholders are last in line to receive any remaining assets after bondholders and preferred shareholders are paid.

Common stock examples

Common stock is widely available, and many of the world's largest companies issue it to raise capital. Major companies like Apple, Amazon, and Tesla issue common stock, attracting investors looking for significant growth potential. These stocks often appeal to those looking for capital appreciation due to their visibility and market dominance.

Investing in common stocks allows shareholders to benefit from the companies' potential success through capital gains and, sometimes, dividends, although these are never guaranteed with common stock.

*Disclaimer: The companies mentioned above are not Saxo's investment recommendations. Please do your own research before investing in the stock market.

Advantages of common stock

Common stock offers several advantages, particularly for investors who are looking to benefit from a company's growth over time.

Here are the main benefits:

Higher potential for capital appreciation

Common stockholders have a greater opportunity to benefit from price increases as a company grows and becomes more profitable. If the company performs well, the stock price can rise substantially, offering significant capital gains for investors over the long term.

Voting rights

Common stockholders usually have the right to vote on major corporate decisions, such as electing the board of directors or approving mergers. This gives shareholders a level of influence over how the company is run, which preferred stockholders typically do not have.

Higher liquidity

Common stocks are generally more liquid than preferred stocks. Because they are widely traded on stock exchanges, it's easier for investors to buy and sell common shares quickly, making them more accessible to retail investors and those seeking flexibility.

Disadvantages of common stock

While common stock offers high growth potential, it also comes with several drawbacks that investors should keep in mind:

Higher volatility

Common stock can be more sensitive to market fluctuations compared to preferred stock. Prices can rise or fall dramatically based on company performance, market sentiment, or broader economic factors, making it riskier for investors who want stability.

Dividends are not guaranteed

Unlike preferred stock, where dividends are fixed and paid regularly, dividends on common stock are not guaranteed. They depend on the company's profitability and the decisions of the board of directors. In tough economic times, a company may reduce or eliminate dividends altogether, leaving common shareholders without a regular income stream.

Lower priority in liquidation

In the event of bankruptcy or liquidation, common shareholders are last in line to receive any remaining assets. Creditors, bondholders, and preferred stockholders all have claims before common stockholders, meaning there may be little to nothing left for them.

Conclusion: Choosing between preferred stock and common stock

When you're choosing between preferred stock and common stock, it really depends on what you're trying to get out of your investments.

If you're the type who wants a steady, reliable income without too much stress over daily market changes, preferred stock might be a better fit. If the company decides to make distributions, you’ll get regular dividends and a bit more security, especially if something happens to the company.

On the other hand, if you're willing to take on more risk for the chance of bigger returns down the road, common stock is probably more suitable. With common stock, you're banking on the company growing over time, and you'll get the added bonus of voting rights on major decisions.