In the stock market, there are two broad types of stock -- common stock and preferred stock. While they're both called stock, they operate much differently from one another and have very different potentials for profit. Each has a different risk profile and may be suitable for different kinds of investors.

While the name "preferred stock" suggests that it might be the more popular choice, there are many more common stocks than preferred stocks. However, in any case, you can buy both common stock and preferred stock at any brokerage. But before you jump in and buy either, you'll want to understand their key differences.

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What is common stock?

When investors talk about "stock," they're almost always talking about a company's common stock, and they simply drop the "common" because it's unusual for a company to have preferred stock. All those reports you hear about a 3% rise at Company X are referring to common stock and never about preferred stock. In fact, the price of preferred stock rarely budges at all. And the major indexes -- the Dow Jones Industrial Average, the Standard & Poor's 500, and the Nasdaq Composite -- all consist of common stocks, too.

Common stock is the most typical vehicle companies use for equity financing to raise money for their businesses. A company issues common stock in an initial public offering, or IPO, which is a company's first time selling stock to the public, giving buyers an ownership stake in the business in exchange for cash. A company may subsequently issue more stock in a follow-on stock offering if it needs cash for some other reason, such as to acquire assets or otherwise expand. As owners, stockholders have the right to vote in any shareholders' meetings, such as the annual meeting, as well as any other votes that arise. They also have the right to receive dividends, if the company pays them.

It's worth reiterating this point: The holders of the company's common stock have an ownership stake in the business and can enjoy the privileges of ownership, including any gains in the stock price.

In fact, a rising stock price is one of the two main ways common-stock ownership can reward owners, the other being cash dividends. Unlike preferred stock, common stock in a growing and successful company will tend to rise over time. Such a company is increasing its profit, and so it's creating value. Investors see the value being created, and when they anticipate even more in the future, they bid up the stock. The best stocks have returned more than 20% annually for decades, a truly amazing record. Even the S&P 500 index, consisting of the top American companies, has averaged a 10% annual return over time.

Cash dividends are the other way common stocks reward shareholders. A cash dividend is typically paid quarterly to investors who hold the stock as of a certain date. The annual dividend is typically no more than about a few percent of the stock price. However, the best American companies keep the payout growing over time, sometimes by as much as 10% annually. Many investors buy only dividend-paying common stocks, because they tend to be more stable than stocks held for capital gains.

Why do companies like common stock?

Companies use common stock as a way to relatively quickly raise a lot of capital, sometimes billions of dollars. So common stock allows companies to expand quickly and potentially have an advantage over smaller, private companies with less financing. In addition, having a common stock listed on an exchange gives companies a potential source of funds if they need to raise money in the future. They can often turn to the market and sell more stock in a follow-on offering. That access to funding creates stability and provides a higher level of prestige for the company and its employees.

To understand another reason companies like common stock, you have to understand something about the other major way for a company to raise money: issuing debt. When a company sells a bond, it promises to pay a preset amount of interest annually for the life of the bond and then repay the bond's principal when the bond matures. Debt can be a risky way to finance a company, because if the company is unable to pay the interest it owes, the company can go bankrupt and forfeit all its assets.

With common stock, however, a company has no such financial obligations. It doesn't even have to pay a dividend. So a company financed only with common stock and no debt won't go bankrupt. That's much safer for the company, but it's much more risky for shareholders, who are not promised any return at all, in contrast to a bond, with which they're promised some level of annual return.

If shareholders are dissatisfied with the return they're receiving on their stock, they can either sell the stock or try to change the management team. The latter course of action is tremendously difficult and often requires having many dissatisfied shareholders work en masse to dislodge management.

Why do investors like common stock?

The biggest reason investors like common stock is for its potential to make its owners wealthy. Because stockholders are owners of the company, they enjoy the stream of profit the company earns, although they aren't able to take it out of the business. Investors look for companies that are likely to succeed in the future, establishing dominant positions in thriving industries. Such businesses are likely to grow their earnings, and their stocks are likely to rise in the future, often many times in value. A successful company held for decades could even return an investor's initial investment hundreds of times.

In addition to capital gains, many common stocks also pay a cash dividend. Dividend-distributing companies are particularly popular among investors who need regular cash income today and don't want to wait for a stock to go up (or down) in the future. Dividend stocks are particularly popular with retirees, and the best ones -- those that have a well-covered dividend and can increase it over time -- are great because they offset the effects of inflation, which diminishes the purchasing power of money.

Common stocks also have a tax advantage over preferred stocks. The investor isn't liable for taxes on any capital gains until the common stock is sold. The stock could be held for decades tax-free, increasing in value many times. However, any dividend the company pays will incur a tax. You can't win 'em all.

What is preferred stock?

While it carries the moniker "stock," preferred stock is much more like a bond than a stock. Like a bond, preferred stock pays set distributions on a regular schedule, usually quarterly. It also has a par value, typically $25 per share -- the price at which the company can redeem the preferred stock -- compared to a bond's par value of $1,000. Finally, like a bond, preferreds tend to be sensitive to interest rates, falling when rates rise and vice versa. The prices of already-issued bonds and preferred stocks rise as interest rates fall, because these investments pay relatively better than newer lower-yielding assets. Conversely, when rates rise, already-issued bonds and preferred stocks are relatively less attractive. 

So why is it called preferred stock? Because whenever the company pays dividends or other distributions, preferred stock receives its full payout before common stock receives anything, but after the company's bonds receive their payout and anything else they're due. If the company is unable to pay a distribution on the preferreds, then common stock receives no payout and will continue to receive no payout until the preferred stock receive its due. This seniority structure makes this class of stock preferred over common. 

But while preferreds and bonds share some similarities, preferreds have some other interesting features that investors should be aware of.

  • Preferreds often pay more than a company's bonds. That's because they're perceived as being riskier than the bonds. And it's true, because preferred stock receives distributions only if the bonds receive their payouts. But riskier doesn't necessarily mean risky. For example, the bonds and preferred stock of a highly rated company can both be considered safe, even though the preferreds are relatively riskier than the bonds. 
  • Preferreds can be perpetual. Unlike bonds, preferreds can remain issued in perpetuity, with no maturity date. In other words, they can remain outstanding forever. For a company that needs permanent capital, this feature can be useful. Because preferred stocks can be perpetual, the company may never redeem the stock, meaning the owner can hold it indefinitely, enjoy the payout, and not risk it being bought back.
  • Dividends can be skipped and postponed indefinitely. One of the most unusual features on preferreds is that the issuing company can skip the dividend, and it can do so indefinitely. That will cause the preferred stock to drop in value, and it will mean the common stock won't receive a dividend. But it's not a default, as it would be with a bond.
  • Preferred dividends can be cumulative or non-cumulative. If a company does decide to skip a dividend, it may or may not have to pay that dividend back later. That depends on whether the preferred stock is cumulative or non-cumulative. Cumulative stocks require the issuing company to pay all missed dividends, while non-cumulative stocks don't have this provision.

These features make preferred stocks a much different beast from bonds.

Which industries typically use preferreds?

Very few companies use preferred stocks, and they're only usual in a few industries. The most typical industries are real estate investment trusts (REITs), banks, insurance companies, utilities, and master limited partnerships.

Many financials rely on non-cumulative preferred stock to fund themselves, and preferreds are a useful option because they don't count as a liability but as equity. That means a bank can bolster its equity even though it's issuing what is essentially a debt-like security.

Among REITs, it's much more common to see cumulative preferreds. These REIT preferreds are especially attractive because REITs exist only to distribute their earnings as a dividend. So the REIT has to get into serious trouble before it cancels the dividend. If the company's performance is weakening, it can often issue new common stock to buy more property, potentially hurting the dividend on common stock but improving the dividend coverage of the preferred stock.

Why do companies like preferred stock?

Preferred stock is an attractive financing vehicle for companies because it gives them a lot of flexibility:

  • Since preferreds can be perpetual, they can potentially offer permanent capital for a company.
  • They also allow the company to miss a payment without causing a default.
  • Since preferreds are considered equity and not debt, they don't usually count against a company's debt ratios and actually improve them.
  • If they're past their call date -- the earliest date the company can redeem them at par value, typically five years for new issues -- preferreds can be refinanced, so if the interest rate is lower at the time, a company can move down to an even lower rate, potentially in perpetuity.

If there's a downside for companies using preferreds, it's that preferreds pay dividends after tax, so all those payouts are not tax-deductible. However, that's not really a problem in the REIT world, where there's little or no tax anyway. And it's another reason REITs issue preferreds.

Why do investors like preferred stock?

Preferred stock is popular with investors for one main reason: The yield is high. But there are others:

  • In addition to the high yield, preferreds are less risky than dividends on common stocks, because they get paid before.
  • Preferred stock doesn't get diluted , as does common stock, so preferreds are less risky than common. Dilution occurs when a company issues common stock and buys assets that earn less than they should, hurting the value of all the common stock and the potential future return. With preferred stock, however, the company has an obligation to pay the dividend, and issuing more preferreds doesn't remove that obligation.
  • In companies that exist to pay dividends, management can always issue more common stock to shore up earnings, a move that helps the preferreds even if it hurts the common stock.

One major downside to preferreds is that companies can refinance them just as they're paying attractive relative yields. In other words, when interest rates are low, preferreds past their call date can be expected to be refinanced at lower rates. In addition, preferreds have limited upside and typically will not appreciate much higher than par value.

Common stock vs. preferred stock -- Which kind of stock is right for you?

So let's sum up some of the key difference in what an investor can expect from owning each of these stock types.

Factor

Common Stock

Preferred Stock

Potential upside

Can rise for decades, virtually unlimited

Basically limited to the dividend and can be sold at par value, usually $25

Potential downside

Can fall to $0

Can fall to $0 but less likely to do so

Risk

More risk

Less risk

Volatility

Fluctuates a lot

Fluctuates less or very little

Better for which kind of investor?

Long-term-oriented capital gains

Needs dividend income today

Taxes

No tax paid on capital gains until stock is sold; taxes liable on dividends each year

Taxes liable on dividends each year

How many types?

Usually only one type, though sometimes companies issue a special class with more voting rights

Often the company has many series, and there's no limit to how many can be issued

While there are always exceptions to these guidelines -- for example, preferred stock purchased at a substantial discount to par value can rise significantly, but not usually higher than par -- this table lays out the key distinctions between the two classes of stock.

How do investors buy common stock or preferred stock?

Investors can buy either type of stock through any online stock broker. The key difference is in the ticker symbols, with preferred stocks having a specific type of symbol to differentiate them from common stock.

While a company usually issues only one kind of common stock, it may issue many different series of preferred stocks. These series are named after the letters of the alphabet, starting with A. Each series has its own specific terms, conditions, and expirations, so you have to know which exact series you want to purchase. As you're entering your order at the broker, be careful that you've entered the right ticker.

Take the REIT Public Storage (NYSE:PSA), for example. It's listed on the New York Stock Exchange and has a three-letter ticker, typical for stocks listed there. (Stocks listed on the Nasdaq usually have a four-letter symbol.) The company also has many series of preferred stocks, too, and they're listed on the same exchange. The preferred tickers use the base symbol for the common stock -- here PSA -- and then adds a suffix to distinguish the preferred series. For example, Yahoo Finance shows the following:

  • PSA -- for the common stock
  • PSA-PD -- for Series D preferred stock
  • PSA-PE -- for Series E preferred stock
  • PSA-PW -- for Series W preferred stock

And the list goes on, because Public Storage is one of the most prolific issuers of preferreds.

It's also worth noting that brokers use various suffixes to designate preferred stocks. While Yahoo! Finance uses "-PD", one broker might use "-D" or ".D" or even "PRD" to indicate the same Series D preferred stock. It can become confusing, especially if you use more than one broker to buy preferreds.

The bottom line

As with all investments, whether common stock or preferred stock (or both) is right for you depends on your financial situation, your temperament, and your needs. Common stock is great for those who have a long time horizon and many years before they'll want to use any capital gains from their investment, whereas preferred stock is better for investors who need dividend income now or in the immediate future. Of course, if you want a little of both, you can build a portfolio that suits you best.

 

Jim Royal owns shares of Public Storage. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.