To understand the differences, let’s start with some of the similarities. Both types of stock represent an ownership interest in a company. The success of both investments is tied to the profitability of that company.
In other words, they both share in some form or another, in those profits or losses. Both require considerable risk of loss, especially when compared to owning bonds from the same company or just keeping your money in cash.
Now on to the differences. These are two different classes of shareholders, with differing ownership rights. Simply put, preferred shareholders have a greater claim on both the assets and any profits of a company. That reduces risk, but they also have less potential for growth on the upside. On the other hand, there is less certainty with common stock, but greater potential for gain. Common stockholders also have voting rights to influence the company’s operations and management whereas preferred shareholders generally do not have such rights.
To illustrate the differences, think about the flow of profits in a company. The profits would first go to pay off existing debt obligations (i.e. the bondholders that have loaned money to a company). Next, if there is anything leftover, the preferred stockholders would be paid first, up to the dividend level specified for the specific class of stock. Finally, if anything is left after paying the preferred stockholders, the remaining profits are paid to the common stockholders, or it accrues to their benefit in the form of retained earnings and growth.
Here is an example with numbers. Say ABC Company experiences an operating profit in 2011 of $100,000. They use the first $15,000 to pay interest to their bondholders. Their agreement with their preferred stockholders is to pay 8 percent on the par value of the preferred stock, which let’s assume would be $95,000.
However, there is only $85,000 available to pay out. So the $85,000 is paid to the preferred shareholders and the common stockholders get nothing. Sometimes the unpaid amounts to the preferred shareholders, like the $10,000 that was unpaid in this example, would accrue until paid off (e.g., the next year the company would owe $105,000 in dividends to the preferred shareholders if profits allowed), but it depends on the agreement specifics.
If there are no profits indefinitely, the preferred shareholders do not have rights to getting their dividend paid. In that way, they still experience greater risk than a bondholder or lender to the company.
Next, assume that in 2012 ABC Company goes under and has to dissolve itself. In that case, preferred shareholders will be paid back from the company’s assets before common shareholders get anything.
As you can see from the example, the preferred shareholders experience less risk than the common stockholders, but there is also less potential for return. Say that ABC Company experienced a huge year in 2012 instead of dissolving and they had $1,000,000 in profits. The preferred shareholders would get their fixed dividend payout, but everything extra would accrue to the benefit of the common stockholders.
Put on the risk/reward scale, preferred stock lands somewhere between bonds and common stock.