Principles of Finance

Learning Goal: I’m working on a finance writing question and need an explanation and answer to help me learn.

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Explain the difference between valuing for preferred stock and common stock and how to calculate for each. Be sure to support your statements with logic and argument, citing any sources referenced.

Both preferred stock and ordinary stock are equity securities, but they have several key differences. As dividend payments to preferred shareholders must be made first, preferred stock initially receives a set dividend. However, common stockholders may not receive a dividend. Earlier to issuing any dividends to ordinary stockholders, a firm may completely pay all dividends (including from prior years) to preferred investors.

Second, preferred stock usually does not participate in price growth (or decline) to the same extent as common stock. The recurring cash dividends preferred stock holders receive represent its intrinsic worth. On the other side, it is more challenging to evaluate common stock. Investors keep common stock, however, since it is not reliant on semi-fixed payments, because of the possibility of capital growth. When it comes to common stock, each share comes with one voting right, and shareholders can utilize these rights to choose the directors of the company at the annual public meeting. But preferred stocks often do not come with any voting rights.

Finally, the terms and circumstances for the two forms of equity vary. Common investors have the power to vote, but preferred owners often do not. Shares of preferred stock may be convertible into common stock, but not vice versa. Preferred shares can be callable, meaning the business might seek to buy them back at par. Additionally, preferred stock is treated more favorably during liquidations.