What is the difference between common stockholders and preferred shares owners in terms of receiving dividend payments?

 

Difference between common stockholders and preferred shareholders in terms of dividends

 

     Investing in a company’s stock provides individuals with ownership rights, but not all stocks are created equal. Investors can purchase two main types of stock: common stock and preferred stock. Both represent ownership in a company, but they come with different rights and responsibilities, especially when it comes to dividend payments. Dividends play a significant role in stock ownership, often providing a source of income for investors. The way these dividends are handled, however, differs depending on whether an investor holds common or preferred shares.

 

    In this article, we will explore the differences between common stockholders and preferred shareholders in terms of receiving dividend payments and how this can affect an investor’s portfolio strategy.

 

Overview of common stock

 

     Common stock is the most frequently issued type of equity in a company and represents the majority of ownership stakes in public companies. When people refer to "stocks" in general, they are usually referring to common stock. Investors who hold common stock are entitled to several benefits, such as voting rights in shareholder meetings and the potential for capital gains as the value of their shares increases over time.

 

    However, dividends for common stockholders work differently from those of preferred shareholders. Here are the key characteristics related to dividend payments for common stockholders:

 

Dividend discretion:  One of the fundamental aspects of common stock is that dividend payments are not guaranteed. Companies are under no obligation to pay dividends to common stockholders. Whether or not a dividend is paid depends on the company’s financial performance, profitability, and strategic goals. If a company is in a growth phase, it may opt to reinvest profits into expanding operations rather than distributing dividends to shareholders. This is common in sectors such as technology, where companies often prioritize growth over dividend payments.

 

     The decision to declare dividends is made by the company’s board of directors, who assess the company’s financial health and other factors. Even if the company has paid dividends in the past, there is no guarantee that it will continue to do so, particularly during periods of financial difficulty or market downturns.

 

Variable dividend payments:  For common stockholders, the amount of dividends can fluctuate. Unlike preferred shareholders, who receive a fixed dividend rate, common shareholders may experience varying dividend payments based on the company’s performance in a given quarter or year. A company that generates strong profits may increase its dividend payouts, while weaker performance could lead to a reduction or suspension of dividends.

 

    This variability makes common stock riskier in terms of dividend income but also offers the potential for dividend growth. As a company matures and becomes more profitable, it may increase the dividends paid to common shareholders over time. For long-term investors, this potential for growth can be appealing.

 

Last in line for dividend payments:  In terms of priority, common stockholders are at the bottom of the hierarchy when it comes to receiving dividends. Preferred shareholders and bondholders are paid first. If a company is facing financial challenges, common shareholders might not receive any dividends at all until these other obligations are met. Therefore, while common stockholders have the potential for capital appreciation and growing dividends, they take on a higher risk when it comes to the consistency of dividend payments.

 

Voting rights and influence on dividends:  Common stockholders generally have voting rights, which allow them to influence the direction of the company, including decisions regarding dividend payments. Common shareholders can vote on important issues such as the election of the board of directors, mergers, acquisitions, and other significant corporate policies. While common shareholders do not directly vote on whether dividends will be paid, their voting influence can affect the overall corporate strategy and profitability, which in turn may impact dividend policies.

 

Overview of preferred stock

 

    Preferred stock, as the name suggests, provides shareholders with a preferential treatment over common stockholders when it comes to dividend payments and, often, the distribution of assets in the event of liquidation. Preferred shares are often considered a hybrid between stocks and bonds, as they offer fixed income-like payments while also representing an ownership stake in the company. Here are the main characteristics of dividends for preferred shareholders:

 

Fixed dividend payments:  One of the key benefits of preferred shares is the fixed dividend that they typically offer. Preferred shareholders receive a specific, pre-determined dividend amount, which is generally expressed as a percentage of the share’s face value or par value. For example, a preferred stock with a par value of Rs.100 and a 5% dividend rate will pay shareholders Rs.5 annually, regardless of the company’s earnings for that year.

 

     This fixed dividend rate makes preferred shares particularly attractive to investors seeking stable income rather than capital appreciation. It also makes them more predictable in terms of income, especially compared to the variable nature of common stock dividends.

 

Priority in dividend payments:  Preferred shareholders have priority over common shareholders when it comes to receiving dividends. This means that if a company decides to pay dividends, it must first fulfill its obligations to preferred shareholders before distributing any remaining profits to common stockholders. This priority status provides a layer of security for preferred shareholders, particularly in times when a company may have limited profits available for distribution.

 

Cumulative dividends:  Many preferred shares come with a feature known as cumulative dividends. This means that if the company is unable to pay the preferred dividend in a given year, the unpaid dividend accumulates and must be paid out to preferred shareholders before any dividends can be issued to common stockholders in the future. These unpaid dividends are referred to as “dividends in arrears.”

 

    For example, if a company with cumulative preferred shares misses a dividend payment, the unpaid amount will accumulate, and the company must pay these backlogged dividends to preferred shareholders before resuming dividends for common stockholders. This adds another layer of protection for preferred shareholders in terms of dividend security.

 

Non-participation in dividend growth:  Unlike common shareholders, who may benefit from dividend growth as the company’s profits increase, preferred shareholders typically do not see any increase in their dividend payments. The dividend rate for preferred shares is fixed and does not adjust upwards, even if the company’s earnings improve significantly. This fixed-income aspect is similar to the way bonds operate, providing stability but limiting upside potential.

 

No voting rights:  Preferred shareholders typically do not have voting rights. While they enjoy preferential treatment in terms of dividend payments and liquidation priority, they generally do not have a say in corporate governance. This is one of the main trade-offs for preferred shareholders—greater dividend security but less control over the company’s decisions.

 

Convertible features:  Some preferred shares include a convertibility option, which allows shareholders to convert their preferred stock into common stock under certain conditions. This conversion feature can be attractive if the company’s common stock price rises significantly, giving preferred shareholders the opportunity to benefit from potential capital appreciation. However, once converted, the investor forfeits their fixed dividend and other preferential rights.

 

Key differences in dividend payments

 

To summarize, the key differences between common stockholders and preferred shareholders in terms of dividend payments can be boiled down to several important factors:

 

Dividend security:  Common stockholders face uncertain dividend payments, which depend on the company’s profitability and decisions made by the board of directors. Preferred shareholders, on the other hand, enjoy fixed dividends, providing a more reliable income stream.

 

Priority:  Preferred shareholders have priority over common stockholders when it comes to receiving dividends. This means they are paid before common stockholders, making preferred shares less risky in terms of dividend reliability.

 

Growth potential:  Common stockholders have the potential to benefit from dividend growth as the company becomes more profitable. Preferred shareholders, however, generally do not participate in dividend growth and are limited to their fixed dividend rate.

 

Voting rights:  Common stockholders typically have voting rights, giving them influence over corporate decisions, including those related to dividend payments. Preferred shareholders usually do not have voting rights, though they receive preferential treatment in dividend payments.

 

Cumulative dividends:  Preferred shareholders often benefit from cumulative dividends, ensuring that any missed payments accumulate and must be paid in the future. Common stockholders do not enjoy this protection.

 

Conclusion

    The choice between investing in common stock or preferred stock largely depends on an investor’s financial goals and risk tolerance. Common stockholders are rewarded with the potential for capital appreciation and dividend growth, but they also take on more risk in terms of inconsistent dividends and lower payment priority. Preferred shareholders, meanwhile, receive more reliable and prioritized dividend payments, but they forfeit voting rights and the opportunity to participate in the company’s growth.

 

    In terms of dividend payments, preferred shareholders generally have the upper hand due to their fixed income and priority status, making their shares appealing to conservative investors looking for steady income. Common stockholders, while taking on more risk, have the potential for greater rewards in the long term through dividend growth and capital gains. Ultimately, the decision to invest in common or preferred stock will depend on an individual’s investment strategy, risk tolerance, and income needs.