Understanding Stocks

Investors who dabble in the stock markets may be confused by the terms and jargon used to describe various financial instruments. What is the difference between common and preferred stock? Most investors are probably familiar with common stock and trading on websites such as cmc markets; but what are they missing out on?

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Common stock is generally regarded as the instrument by which individuals invest in and gain some small control over a corporation, since these stocks are traded as shares of ownership in a company. Each share of common stock may have “voting rights” which grants the ability of a stockholder to cast one vote for each share of stock they own — usually on matters concerning the company’s Board of Directors or the company’s charter. Some companies pay dividends, which is a way a company can distribute profit to the shareholders — owners — of a company.

Preferred stock, while serving much the same purpose, may be handled very differently than common stock. Preferred stock may carry no voting rights, which is a way a company can separate control operations (votes) from financing operations (selling stock). Since preferred stock is often more expensive than common stock, it can be used by a company to raise money without abdicating control of the company. On the other hand, preferred stock may carry more voting rights than common stock — 5 or 10 votes per share, in some cases. It’s up to the company to decide how to structure their preferred stock. Preferred stocks are usually offered to company insiders or ground-floor investors and may even be made available long before an IPO makes common stock available to the general public.

What is the preference implied by the term “preferred stock”? Holders of preferred stock enjoy preferential treatment in dividends, convertibility, and liquidation.

In most cases, when a company announces a dividend, the holders of preferred stock get a bigger slice of those distributed earnings. In fact, preferred stockholders may even be “owed” dividends from previous accounting periods if no profits were shared — a dividend announced in Q2 might have to first satisfy these cumulative “dividends in arrears” owed to preferred stockholders for Q1. Only after these cumulative dividends are settled will common stockholders realize any income.

Holders of preferred stock may also enjoy the convertibility of their stock to common stock. This can benefit the shareholder when the market value of common stock rises to the point at which a preferred share that is convertible to say, 5 shares of common stock, is worth more after conversion. A $100 preferred share is nice, but 5 shares of $25 common stock is better. Other benefits of preferred stock are, of course, forfeited upon conversion.

If a company fails and its assets liquidated, a preferred shareholder gets preferred status over the common stockholders when that cash is distributed. By the time the creditors and preferred shareholders are done with a failed corporation’s liquidated assets, the common shareholders might be left with nothing. Since a preferred share may carry more risk (higher price per share, for instance), they also carry more reward.

A typical investor may never have the opportunity to purchase preferred shares of a company, but knowing the difference between the types of stock makes for a savvier investor.