What is preferred stock, and how does it differ from common stock?
Preferred stock is a type of security that can grant special benefits to its holders. Preferred shares also have some restrictions, which are important to understand before taking the leap to own this type of investment.
How do preferred stocks differ from common stocks? The short answer is that preferred stock sits squarely in between debt financing (i.e., corporate bonds) and equity financing (i.e., common stock), offering attributes of each.
Key Points
- Preferred stock pays a fixed return.
- Preferred stock ranks higher than common stock in the capital stack.
- Preferred stock comes with some limitations that are key to understand.
What is preferred stock?
Preferred stock is a type of equity security that guarantees (except in extreme cases) a fixed rate of return and may confer other benefits as well. Holding preferred stock represents ownership (“equity”) in a company; it usually generates investment income by paying a fixed dividend on a monthly, quarterly, or annual basis. The dividend payment from a preferred stock is similar to the coupon payment of a bond. For this reason, preferred stock is typically considered a hybrid security.
Investing in preferred stock has a similar risk profile to bond investing. For example, an investor may not receive an expected yield if the company that issued the preferred stock declares bankruptcy.
Preferred stock vs. common stock
The following table compares some of the features of preferred stock versus common stock.
| Feature | Preferred stock | Common stock |
|---|---|---|
| Yield | Fixed | Variable |
| Capital stack seniority | Senior | Junior |
| Voting rights | None | 1 share = 1 vote |
| Pricing | Dividend discount model | Market based |
| Price growth potential | Low | Moderate to high |
| Price volatility | Low | Low to high |
| Liquidity | Moderate to low | Moderate to high |
Let’s unpack each of these features.
Yield
Investors in preferred stocks generally know in advance how much they’ll earn, because the dividend is paid at a fixed rate. The fixed interest rate is a percentage of a fixed value (the par value) for the preferred share.
Common stocks have no such yield guarantees—dividends are never guaranteed on common shares— but they also have no structural cap on how much yield they can generate. (Common dividends can be raised at any time.) Common stocks also generate returns for investors through price appreciation. The yield and price growth of a common stock is affected by the performance of the underlying company and by general market conditions.
Capital stack seniority
The yields paid by preferred stocks are essentially a guarantee, but investors in preferred stocks can still be affected in extreme circumstances. For example, if the issuing company is facing a cash crunch or if bankruptcy may be imminent, it may suspend dividend payments on preferred shares. During a 2023 bank run, First Republic Bank (FRC) announced it would be canceling preferred dividends unless and until its cash flow situation reverses.
Lenders and other creditors (including bondholders) typically have the most seniority in the capital structure of a company, meaning they get paid first if assets are liquidated in bankruptcy. Preferred stock holders are compensated after creditors. Common shareholders are junior to both the holders of preferred stock and the company’s lenders. This junior position of common stock in the capital stack means that common shareholders may not receive any compensation in the event of a bankruptcy.
Voting rights
Preferred stockholders have fixed yields and a desirable place in the capital structure, but typically no voting rights. Preferred stockholders generally cannot vote on proxies, elect board members, or otherwise contribute to making decisions for the company. Companies sometimes grant limited voting rights to preferred shareholders if dividend payments are in arrears.
Owners of common stock can benefit from having voting rights with the company. A single share commands a single vote, providing an incentive for some investors to boost their share counts to increase their voting influence. Allocating voting rights in direct proportion to common stock ownership is a core principle of public company structure.
Pricing
How much do preferred stocks cost? The value of a preferred stock is generally stable over time, and can be determined using a simple equation or financial calculator. Preferred stocks are priced using the dividend discount model, which calculates the worth of a preferred stock as the value of the dividends forthcoming plus the value of the underlying security. The dividend payments are discounted to their value in the present day.
The pricing for common stock is much less predictable, but perhaps easier to understand. Common shares trade on exchanges such as the New York Stock Exchange (NYSE) or Nasdaq, with prices determined by supply and demand. High-performing stocks in bull markets are much more likely to command high prices than, say, underperformers in recessionary conditions.
Price volatility and growth potential
The price of a preferred stock is unlikely to grow significantly over time, similar to the way a bond’s price tends to stay relatively stable. The fixed nature of the yield on a preferred stock contributes to the security’s price stability.
In other words, prices of preferred stocks are, in general, less volatile than those of common stocks, just as the bond market tends to be less volatile than the stock market. But that’s not always true. For example, in 2022 and 2023, when the Federal Reserve embarked on an aggressive inflation-fighting rate hike cycle, the bond market—and the prices of many preferred stocks—was quite volatile.
A common stock can have a high potential to increase in price. The common stocks of successful, profitable companies can become increasingly expensive as the company grows, potentially generating attractive returns for patient investors. The price growth potential of common stocks is not guaranteed, but generally exceeds the capital appreciation of preferred shares.
Liquidity
How easy is it to buy or sell preferred stocks? That just depends. Preferred stock may be offered by large, publicly traded companies with ample liquidity, but this type of security is also frequently issued by private companies with very low or no trading volumes. A preferred share in a private company can be difficult to trade or sell.
The liquidity of common stocks is generally high. Common stocks trading in the public markets can generally be bought and sold with ease, with the largest companies usually having common stocks with the most liquidity. An investor wishing to frequently trade securities can benefit from the liquidity of common stocks.
The bottom line
Do preferred stocks have a place in your portfolio? If you like the idea of bond-type returns with the potential for price appreciation, you’re comfortable with the slightly elevated liquidity and credit risk, and you’re okay with not having voting rights, preferreds are worth a look.
But know that preferreds aren’t issued by every company, and some are more risky than others. Conduct your own due diligence, compare yields and credit ratings, and if you’re still unsure, start with smaller investments and work your way into larger positions once you’re comfortable.
That’s the preferred way.