Common and Preferred Stock

Equity means ownership. When you buy stock you own a piece of a company, and the type of stock decides what that ownership gets you. Products are 44% of the SIE, the biggest section, and equity questions run all through it.

Common stock: ownership with a floor under your losses

Common stock is a security that gives you a share of ownership in a company. Own 1,000 shares of a company with 1,000,000 shares outstanding, and you own one tenth of one percent of it.

Ownership brings limited liability, which means the most you can lose is the money you paid for the shares. If the company runs up debts it cannot pay, its creditors cannot come after your house or savings. Your $5,000 stake can fall to zero, and zero is the floor.

Common stock carries the residual claim, the right to whatever is left after everyone else has been paid. On the way up that leftover has no ceiling. On the way down it is often nothing.

The liquidation ladder

When a company liquidates, it sells its assets and pays claims in a fixed order. Learn the order; the exam asks it directly.

• Secured creditors, the lenders who hold specific collateral.
• Unsecured creditors: general creditors, unpaid wages and taxes, and debenture holders (debentures are bonds with no collateral).
• Subordinated debt holders, who agreed to stand behind other lenders.
• Preferred stockholders, who hold equity with a fixed dividend.
• Common stockholders, last in line.

Every debt holder is paid before any stockholder. The exam likes to hide preferred stock among the bonds, to see whether you promote it above debt. Preferred is still equity, so it ranks behind all debt and ahead of common.

Voting: statutory and cumulative

Common stockholders elect the board of directors and approve big corporate changes such as stock splits and mergers. A company can also issue a non-voting class of common stock, so common and voting are not automatic. Preferred stock usually carries no vote at all.

Two voting methods exist. Both give you the same number of votes; only the way you spend them changes.

Statutory voting allows up to one vote per share for each open board seat, with no way to favor one candidate.

Cumulative voting gives the same total and lets you pile all of it on one candidate.

You own 100 shares and four board seats are open. You get 400 votes either way.

• Statutory: at most 100 votes for each of the four candidates.
• Cumulative: all 400 on one candidate, or any split you like.

Cumulative voting helps the small stockholder, because concentrating votes gives a minority holder a real chance to elect one director. Statutory voting favors the largest holder, who can carry every seat.

Preferred stock: income first

Preferred stock is an equity security that pays a fixed dividend and ranks ahead of common stock. It behaves more like a bond. Three features define it.

• A fixed dividend, stated as a percentage of par value. Par is normally $100, so a 6% preferred pays $6 per share each year.
• Priority over common. The company pays the preferred dividend in full before common stockholders get anything, and preferred outranks common in liquidation.
• No vote, in most cases. Preferred stockholders trade the vote for the steady income.

The preferred dividend is fixed, and it is not guaranteed. The board can vote to skip it, and skipping is not a default, which is the sharp difference between preferred stock and a bond.

Cumulative and participating preferred

Straight preferred, also called non-cumulative preferred, loses a skipped dividend for good. Cumulative preferred carries it forward. Skipped dividends pile up as dividends in arrears. The company must clear every arrears dollar plus the current year before common stockholders receive a cent.

You hold cumulative preferred that pays $5 a year. The board skips two years, then wants to pay a common dividend. It owes you $10 in arrears plus $5 for the current year, so $15 per share, before common gets anything.

Participating preferred pays its fixed dividend and then shares in extra dividends alongside common when profits are strong. It is rare in the market and frequent on the exam.

Preferred prices follow interest rates

The preferred dividend never changes, so preferred stock prices move opposite to interest rates, the same way bond prices do. Rates rise, and a share paying a fixed $6 looks poor next to newly issued shares paying more, so its price falls.

Preferred stock therefore carries interest rate risk, the risk that rising rates cut the price of a fixed-income investment. Common stock does not behave this way, because its dividend can grow and its price responds mostly to earnings.

Convertible preferred

Convertible preferred stock can be exchanged for a set number of common shares, at the holder's choice. The conversion ratio states how many common shares one preferred share becomes.

Take a $100 par convertible preferred with a conversion ratio of 4. If the common trades at $30, conversion turns that $100 par share into $120 of common stock, so converting pays. If the common trades at $20, conversion produces only $80, so you keep the dividend instead.

Convert and you give up the fixed dividend and the liquidation priority, and you receive common stock with its vote and its growth. Because that feature is worth something, convertible preferred pays a lower fixed dividend than straight preferred from the same company. Common stock itself is not convertible; conversion runs into common, never out.

How this gets tested

Most questions put a holder in line, count votes, or compare two securities.

"Which is paid first in liquidation, a debenture or preferred stock?" The debenture. A debenture is unsecured debt, and all debt outranks all equity.

"An investor owns 200 shares and three seats are open. How many votes under cumulative voting?" 600, and all 600 can go to one candidate. Statutory voting also gives 600, capped at 200 per candidate.

"Interest rates rise. What happens to a straight preferred?" Its price falls.