Recently, a reader of my book, “Choose Stocks Wisely,” asked about the difference between common stock and preferred stock since he had come across these two types of stock in books he had read. This is an important issue since some corporate balance sheets have both types of stock listed under Stockholders’ Equity.
When preferred stock is issued by a company, these holders of preferred shares are not true owners (equity holders) of the company like the common stock shareholders even though the monetary value of preferred stock shown on the balance sheet is again shown as part of Stockholders’ Equity. Ownership gives the right to vote for things like the board of directors and major policies of the company. Common shares always carry voting rights while it is a very rare thing for preferred shares to carry voting rights.
True owners have a residual interest in the business. After all obligations are satisfied, the rest belongs to the residual party, the common shareholder. Preferred stock is kind of a hybrid of debt and equity. It could just as easily be listed under liabilities as under Stockholders’ Equity. However, accounting rules require that it be presented in the Stockholders’ Equity section, primarily giving substantial weight to the fact that preferred stock has no maturity date as do liabilities (debts).
Yet, preferred stock has characteristics that are akin to debt. Preferred stockholders get paid a fixed dividend and this dividend must be paid before common shareholders can receive a dividend. Debt holders receive a fixed interest rate and interest payments must be made before dividends can be distributed to common shareholders. Further, if the company goes bankrupt, the preferred stockholder gets satisfaction before the common stockholder, similar to the debt holder getting paid off before the common stockholder.
So, the preferred shareholder takes less risk than a true owner does in that the preferred shareholder is “preferred” in several ways. Thus, the preferred shareholder does not have the opportunity to reap the “residual or remainder” benefits of true ownership like the common shareholder does, which could be large.
The negative of a preferred stockholder presence on the balance sheet is that the earnings of the company must be shared by the owners (common) with the non-owner equity holders (preferred). This effectively dilutes the common shareholder interest.
How the common stockholder gains from the presence of preferred shares is explained by considering two alternative sources of financing for the underlying company: issuing preferred stock (strange equity) to get needed capital or borrowing money (debt). The debt holder can petition the company into bankruptcy if the interest is not paid on time while the preferred stockholder cannot bankrupt the company for failure to make dividend payments on time.
So, preferred stock is a hodgepodge equity form by which a company can raise money. On the one hand, it effectively dilutes the common shareholder equity interest while, on the other hand, it carries a cheaper cost of capital relative to common stock while avoiding any bankruptcy threat for failure to pay the preferred dividend as scheduled.
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