Preferred vs Common Stock

Table of Contents
1. Core Concepts
2. Comparison of Preferred vs Common Stock
3. Commonly Tested Scenarios / Pitfalls
4. Step-by-Step Procedures or Methods
5. Practice Questions
6. Quick Review
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Preferred stock and common stock are the two main types of equity securities issued by corporations. Understanding the differences between them is critical for the FINRA SIE Exam, as questions frequently test features, investor priorities, risks, and situations where one is preferable over the other. This section covers the structural differences, rights, dividend treatments, and comparative characteristics that appear on the exam.

Core Concepts

Common Stock

Common stock represents ownership in a corporation and gives shareholders voting rights and potential appreciation. Common stockholders are the last in line for claims on company assets and dividends-they get paid only after all debts and preferred stockholders are satisfied.

Key Features:

• Voting rights: Common shareholders typically receive one vote per share on corporate matters such as board elections and major business decisions
• Dividends: Not guaranteed; declared at the discretion of the board of directors and may vary or be skipped entirely
• Capital appreciation: Primary benefit is potential growth in share price
• Preemptive rights: May give existing shareholders the right to purchase additional shares before the public to maintain their ownership percentage
• Lowest priority in liquidation: Receive assets only after all creditors and preferred shareholders are paid
• Unlimited upside potential: No cap on how much the stock can appreciate

When to Use This

• When an exam question asks which security offers the greatest growth potential or capital appreciation-common stock is the answer
• When a question involves voting rights or shareholder control-common stock is almost always correct
• When comparing risk levels among equity securities-common stock has the highest risk among equity types
• When a scenario describes a startup or growth company and asks what investors seeking aggressive growth would buy-choose common stock

Preferred Stock

Preferred stock is a hybrid security combining features of both equity and debt. It pays a fixed dividend (stated as a dollar amount or percentage of par value) and has priority over common stock for dividend payments and asset distribution in liquidation, but typically carries no voting rights.

Key Features:

• Fixed dividend: Stated as a percentage of par value (e.g., 5% preferred with $100 par = $5 annual dividend) or as a dollar amount
• Priority in dividends: Must be paid before any common stock dividends
• Priority in liquidation: Receives assets before common stockholders but after all creditors
• No voting rights: Typically does not vote unless dividends are in arrears
• Less price volatility: Trades more like a bond due to fixed income nature
• Interest rate sensitive: Price moves inversely with interest rates, similar to bonds
• Par value: Usually $100 or $25 per share

When to Use This

• When a question asks which security provides steady income with less volatility than common stock-preferred stock is the answer
• When comparing priority in bankruptcy or liquidation among equity holders-preferred stockholders come before common but after all debt holders
• When a question involves fixed income from equity securities-preferred stock pays fixed dividends
• When interest rates rise and the question asks which equity security will decline in price more predictably-preferred stock behaves like a bond

Cumulative vs Non-Cumulative Preferred

Cumulative preferred stock requires that any skipped (unpaid) dividends accumulate and must be paid in full before any dividends can be paid to common stockholders. Non-cumulative preferred stock does not accumulate unpaid dividends; if a dividend is skipped, it is lost forever.

Key Facts:

• Cumulative: Missed dividends are called "dividends in arrears" and must be paid before common dividends
• Non-cumulative: If the board skips a dividend payment, preferred shareholders have no claim to it later
• Most preferred stock is cumulative unless specifically stated otherwise on the exam
• Common stock never receives dividends if cumulative preferred has dividends in arrears

When to Use This

• When a question states dividends were skipped for two years and asks who gets paid first when dividends resume-cumulative preferred holders receive all arrears before anyone else
• When comparing investor protection between cumulative and non-cumulative-cumulative offers greater protection
• When a scenario describes a company recovering from financial difficulty and resuming dividends-look for cumulative preferred and calculate arrears

Callable Preferred Stock

Callable preferred stock gives the issuing corporation the right to repurchase the shares at a predetermined call price after a specified date. This benefits the issuer when interest rates decline, as they can retire high-dividend preferred and reissue at lower rates.

Key Facts:

• Call price: Usually set above par value (e.g., $102 when par is $100) to compensate investors
• Call protection period: Time during which the stock cannot be called
• Issuer's advantage: Refinance when rates drop, similar to refinancing a mortgage
• Investor's disadvantage: Limits upside potential; stock price will not rise much above call price
• Reinvestment risk: Investors forced to reinvest at lower prevailing rates when called

When to Use This

• When interest rates decline and a question asks which security an issuer would likely call-callable preferred with a high dividend rate
• When comparing investor risks-callable preferred has call risk and reinvestment risk that non-callable does not
• When a question asks why a preferred stock's price isn't rising despite falling rates-it may be trading near its call price

Convertible Preferred Stock

Convertible preferred stock allows the holder to exchange preferred shares for a fixed number of common shares at the investor's option. The conversion ratio determines how many common shares the investor receives per preferred share.

Key Facts:

• Conversion ratio: Number of common shares received per preferred share (e.g., 4:1 means one preferred converts to four common shares)
• Conversion price: Par value divided by conversion ratio (e.g., $100 par ÷ 4 = $25 conversion price)
• Parity price: The point where converting and selling common shares equals the market price of the preferred
• Investor's advantage: Upside potential if common stock appreciates; downside protection from fixed preferred dividend
• Trades at a premium: Convertible preferred typically trades above non-convertible due to conversion feature
• Lower yield: Pays lower dividends than non-convertible preferred because of the conversion privilege

Parity Price Calculation:
To find when conversion is profitable:
\( \text{Parity price of preferred} = \text{Common stock market price} \times \text{Conversion ratio} \)

Example: Preferred converts to 5 shares of common. Common trades at $22.
\( \text{Parity price} = 22 \times 5 = 110 \)
If preferred trades above $110, don't convert. If below $110, conversion is profitable.

When to Use This

• When a question asks which security offers income plus growth potential-convertible preferred provides both
• When common stock price rises significantly and the question asks what convertible preferred holders should consider-calculate parity to determine if conversion is profitable
• When comparing yields-convertible preferred has lower yield than straight preferred due to the conversion feature
• When an investor wants equity participation but with less risk than common stock-convertible preferred offers a middle ground

Participating Preferred Stock

Participating preferred stock receives its fixed dividend plus the opportunity to receive additional dividends if common stockholders receive dividends above a certain level. This feature is rare but testable.

Key Facts:

• Fixed dividend first: Receives the stated preferred dividend before participation
• Participation threshold: Additional dividends paid if common exceeds a specified amount
• Rare in practice: Most preferred is non-participating
• Higher potential return: Can receive more than the fixed dividend in profitable years

When to Use This

• When a question states preferred stockholders received more than their stated dividend rate-likely participating preferred
• When comparing which type of preferred has the highest potential dividend-participating preferred can exceed its stated rate

Comparison of Preferred vs Common Stock

Commonly Tested Scenarios / Pitfalls

1. Scenario: A company has not paid dividends for three years. It now declares a dividend. The question asks who receives payment first among common shareholders, cumulative preferred shareholders, and bondholders.

Correct Approach: Bondholders receive interest first (debt obligation), then cumulative preferred receives all three years of arrears plus current year dividend, then common shareholders if funds remain.

Check first: Whether the preferred stock is cumulative or non-cumulative-only cumulative preferred accumulates arrears.

Do NOT do first: Assume preferred and common shareholders are paid simultaneously or that missing the order of priority. Dividends are never paid to common if cumulative preferred has arrears.

Why other options are wrong: Common stockholders cannot receive dividends before preferred arrears are cleared; non-cumulative preferred would not have arrears to collect; bondholders receive interest payments, not dividends, and always come before equity holders.

2. Scenario: Interest rates in the market increase significantly. A question asks which security will likely experience the greatest decline in market price: common stock or preferred stock.

Correct Approach: Preferred stock will decline more predictably because it has a fixed dividend and trades like a bond-price moves inversely with interest rates.

Check first: Recognize that preferred stock is interest-rate sensitive due to its fixed-income characteristics.

Do NOT do first: Choose common stock based on general volatility-while common is more volatile overall, the question specifically tests the interest rate relationship.

Why other options are wrong: Common stock may be affected by many factors beyond interest rates; preferred stock's fixed dividend makes it directly comparable to newly issued securities at higher rates, forcing its price down to maintain competitive yield.

3. Scenario: An investor owns convertible preferred stock with a conversion ratio of 5:1 and par value of $100. Common stock is trading at $18. The question asks if the investor should convert.

Correct Approach: Calculate parity price: \( 18 \times 5 = 90 \). If the preferred trades above $90, do not convert; if below $90, conversion is profitable.

Check first: Calculate the parity price by multiplying common stock price by the conversion ratio before deciding.

Do NOT do first: Convert immediately without calculating parity or assume conversion is always beneficial because common stock "might" appreciate later.

Why other options are wrong: Converting when preferred trades above parity results in immediate loss; holding common stock hoping for appreciation introduces more risk than maintaining the preferred dividend; ignoring the conversion price or ratio leads to incorrect valuation.

4. Scenario: A corporation announces it will call its 6% preferred stock currently trading at $105 at a call price of $102. The question asks what happens to investors.

Correct Approach: Investors receive $102 per share (the call price), which is a loss from the current market price of $105, and they face reinvestment risk as they must reinvest proceeds at lower prevailing rates.

Check first: Identify the call price versus the current market price to determine if investors gain or lose from the call.

Do NOT do first: Assume investors benefit from a call or that they receive the current market price-the issuer pays only the stated call price.

Why other options are wrong: Investors do not receive market price; the call benefits the issuer by retiring expensive dividend obligations; refusing the call is not an option once the issuer exercises the call right.

5. Scenario: In a bankruptcy liquidation, a question asks the order of payment among common stockholders, preferred stockholders, secured bondholders, and unsecured bondholders.

Correct Approach: Secured bondholders first, unsecured bondholders second, preferred stockholders third, common stockholders last.

Check first: Distinguish between debt holders (all creditors) and equity holders (preferred and common)-debt always comes before equity.

Do NOT do first: Place any equity holder before any debt holder or assume preferred stockholders have priority over creditors.

Why other options are wrong: Common stockholders always come last; preferred stockholders, despite priority over common, cannot be paid until all debt obligations are satisfied; secured creditors have specific collateral claims and come before unsecured creditors.

Step-by-Step Procedures or Methods

Task: Determine if a convertible preferred stock should be converted to common stock

1. Identify the conversion ratio (how many common shares per preferred share)
2. Note the current market price of common stock
3. Calculate parity price of preferred: multiply common stock price by conversion ratio
4. Compare parity price to the current market price of preferred stock
5. If preferred market price > parity price: do not convert (preferred is worth more as-is)
6. If preferred market price < parity price: convert (you gain value by converting and selling common shares)
7. If preferred market price = parity price: investor is indifferent (no gain or loss from converting)

Task: Calculate annual dividend payment for preferred stock

1. Identify the par value of the preferred stock (usually $100)
2. Identify the dividend rate (stated as a percentage or dollar amount)
3. If percentage: multiply par value × dividend rate (e.g., $100 par × 6% = $6 annual dividend)
4. If dollar amount: use the stated amount directly (e.g., "$5 preferred" pays $5 per year)
5. To find quarterly dividend: divide annual dividend by 4

Task: Determine total payment to cumulative preferred with dividends in arrears

1. Identify annual dividend rate per share
2. Count the number of years dividends were skipped
3. Multiply annual dividend × years skipped = total arrears
4. Add current year dividend to total arrears
5. Multiply total by number of shares owned to get investor's total payment
6. Confirm: no common dividends paid until this amount is fully distributed

Practice Questions

Q1: An investor owns 100 shares of 5% cumulative preferred stock with a $100 par value. The company skipped dividends for the past two years but now declares a dividend. How much must the investor receive before any common shareholders are paid?
(a) $500
(b) $1,000
(c) $1,500
(d) $2,000

Ans: (c)
Annual dividend = $100 par × 5% = $5 per share. Two years arrears = $5 × 2 = $10 per share. Current year = $5. Total = $15 per share × 100 shares = $1,500. (a) represents only one year; (b) represents two years without current; (d) represents four years.

Q2: Which of the following statements is TRUE regarding preferred stock?
(a) Preferred stockholders have voting rights equal to common stockholders
(b) Preferred stock dividends must be paid before common stock dividends
(c) Preferred stock has unlimited capital appreciation potential
(d) Preferred stock is unaffected by changes in interest rates

Ans: (b)
Preferred dividends are paid before common dividends, though neither is guaranteed. (a) is incorrect-preferred typically has no voting rights; (c) is incorrect-preferred has limited upside, trading near par; (d) is incorrect-preferred is highly sensitive to interest rate changes, similar to bonds.

Q3: An investor owns convertible preferred stock with a par value of $100 and a conversion ratio of 4:1. If the common stock is trading at $28 per share and the preferred is trading at $115, what should the investor do?
(a) Convert immediately because common stock is rising
(b) Hold the preferred because it is trading below parity
(c) Convert because the preferred is trading above parity
(d) Hold the preferred because it is trading above parity

Ans: (d)
Parity price = $28 × 4 = $112. The preferred trades at $115, which is above parity, so converting would result in a loss ($115 preferred vs. $112 worth of common). Hold the preferred. (a) ignores parity calculation; (b) has the parity relationship backwards; (c) incorrectly suggests converting when above parity, which would create a loss.

Q4: Interest rates in the market decline significantly. Which preferred stock is a corporation most likely to call?
(a) Non-callable preferred with a 3% dividend
(b) Callable preferred with a 7% dividend
(c) Convertible preferred with a 4% dividend
(d) Cumulative preferred with dividends in arrears

Ans: (b)
When interest rates decline, issuers call high-dividend callable preferred to refinance at lower rates. The 7% callable preferred costs the issuer the most and is the best candidate for calling. (a) is non-callable, so cannot be called; (c) convertible preferred typically has lower yields and may not be called if conversion value is high; (d) dividends in arrears do not make a preferred more likely to be called.

Q5: In a corporate liquidation, which of the following has the highest priority claim on assets?
(a) Common stockholders
(b) Preferred stockholders
(c) Unsecured bondholders
(d) Subordinated debenture holders

Ans: (c)
All creditors (debt holders) are paid before any equity holders. Unsecured bondholders come before preferred and common stockholders. Among the choices, (c) has highest priority. (a) and (b) are equity and come last; (d) subordinated debt is junior to unsecured but still senior to equity.

Q6: Which of the following investors would be MOST suitable for preferred stock?
(a) An aggressive investor seeking maximum capital gains
(b) A conservative investor seeking steady income
(c) A young investor with a long time horizon seeking growth
(d) A speculative investor willing to accept high volatility

Ans: (b)
Preferred stock provides fixed income with less volatility, making it suitable for conservative, income-oriented investors. (a), (c), and (d) all describe growth- or speculation-oriented investors who would be better served by common stock or more aggressive investments.

Quick Review

• Preferred stock pays fixed dividends (usually stated as percentage of $100 par value) and has priority over common for dividends and liquidation, but typically no voting rights
• Common stock offers voting rights and unlimited appreciation potential but comes last in liquidation and has no dividend guarantee
• Cumulative preferred accumulates missed dividends (arrears) that must be paid in full before common receives any dividends; non-cumulative does not accumulate
• Preferred stock is interest-rate sensitive-price moves inversely with rates, similar to bonds; common stock is less directly affected by rate changes
• Callable preferred benefits the issuer when rates decline, allowing refinancing; investors face call risk and reinvestment risk
• Convertible preferred conversion ratio determines how many common shares you receive; parity price = common price × conversion ratio; convert only when preferred trades below parity
• Liquidation order: secured debt, unsecured debt, preferred stock, common stock-all creditors before any equity holders
• Convertible preferred has lower yield than non-convertible because of the conversion privilege (upside potential)
• Participating preferred can receive more than its fixed dividend if common dividends exceed a threshold-rare but testable
• Preferred stock is suitable for conservative, income-seeking investors; common stock suits growth-oriented, risk-tolerant investors willing to accept volatility