We now take a deeper look at equities – in particular common stock and preferred stock – in terms of their appeal as well as drawbacks. To recap (briefly) on our previous article on the topic, the most popular equity investments come from acquiring stocks whereby profits are in the form of capital gains or dividends. Stocks bought solely for capital gains provide returns only when a share is sold. Income from stocks can also be derived when the investee releases dividends – a sum of money paid regularly (typically annually) by a company to its shareholders out of its profits (or reserves).
This is what most people are referring to when they mention stocks and shares for investment purposes – common stocks essentially represent owning a part of a company. Their prices rise and fall, with profits being realised when they are sold for more than they are bought for. They also provide income from dividends that are paid out periodically. The dividend amounts (decided by the board of directors) are not fixed and depend on variables such as how well the company has performed over the previous financial period. The company can also decide not to pay dividends for several reasons – this if often the case with companies that are experiencing growth and need to use profits to advance the business.
Common stock also allows stockholders to vote on corporate issues, such as who constitutes the board of directors as well as if a corporation should accept takeover bids. Most of the time, they receive one vote per share. They are also entitled a copy of the corporation’s annual report for a thorough overview of the company’s activities and financial performance. The shareholder can at times maintain the right of first refusal – they basically get offered the right to buy any new stock the company tries to issue before anyone else.
On the downside, common stock holders are last in line to be paid when a company goes bankrupt or enters insolvency. This often amounts to an extremely reduced figure, in stark contrast to what they originally paid for the stock.
Preferred stock is often referred to as a hybrid security – offering investors features of both bonds and common stock. They function as a bond in that they typically have fixed-percentage dividends (which can exceed the stated amount if company profits are higher than a pre-determined level), and they are similar to common stock in that the preferred holder cannot receive a dividend unless it is earned and declared by the corporation.
Because preferred stock pays out dividends at regular intervals, they don’t fluctuate as often as a corporation’s common stock with dividends typically guaranteed. If the company misses one, it will usually be required to pay it before any future dividends are paid on either stock – representative of the cumulative feature of preferred stocks.
Although preferred stockholders (as the name suggests) also get paid ahead of common stockholders in the case of insolvency, they may or may not get a say in how the company is run – they often have limited rights that allow them to vote only if dividends have not been paid out for a certain period of time. This differs from company to company in line with overall investor policies.
Preferred stock can also come with callable and putable clauses, where the issuing company has the right to buy shares back from investors and investors have the right to sell shares back to the issuing company.
It is of point to note that although preferred stock can often be converted to common stock, the inverse is usually not permissible.
And there we have it, a summary of the two major investment instruments that fall under equities. An investor needs to decide his or her priorities when choosing between both classes; choices should be made based on whether having control by maintaining voting rights outweighs the security of fixed and more reliable dividends. Their appeal also lies in a particular investor’s risk appetite, common stocks tend to fluctuate more with higher earning capacity in the long run.
To read more about other basic financial instruments, read Part 1 of this series here.