With common shares, however, a larger portion of shareholders’ total return (or all of their total return for non- dividend shares) is based on future price appreciation and future dividends are unknown. If the company is liquidated, common shareholders will receive whatever amount (if any) is remaining after the company’s creditors and preference shareholders have been paid. In summary, because the uncertainty surrounding the total return of preference shares is less than common shares, preference shares have lower risk and lower expected return than common shares.
I understand that preferred shares have a lower risk, but why they have a lower expected return than common shares? (as preferred shares get paid dividends before common sharesholders that didnt made any sense for me.)
On a philosophical level, if you know preferreds are lower risk investments than the common shares, you have to know they have to have a lower expected return.
On a practical level, preferreds have lower expected returns exactly because they’re lower risk (kinda sounds like what I said above but bear with me). Think of a company’s capital structure. Everything from investment grade bonds, to converts, to preferreds, to common and everything in between. Starting with bonds, if you hold to maturity you know exactly what you’re going to get. Extremely low risk and the lowest expected return. Bondholders have a better claim to the company’s assets so they’ve agreed to lower returns for that safety net. As you move towards riskier instruments, you’ll notice more of your expected return is comes from price appreciation (speculation) and not steady interest/dividend payments. Basically you’re betting on the company’s future with common shares compared to betting on the company’s ability to pay the interest on their debt to their bondholders now. You can see how one is inherently more risky, but possible much more profitable?
I will try to say whats on my mind, like he guy above stated Preferred Stock have a fixed dividend, what I know the Total Return depends on price appreciation and the dividends, but the thing is the Common Stock only gets paid if the Preferred gets paid first (and the dividend is not obligatory, different from interest in bonds), so what if the company pay the dividends for only the Preferred Shares and not to Common Shares, in my vision the Preferred Shares needs to have a higher return because it gains price appreciation and the dividends while the common shares only get the price appreciation.
I can only agree with you on the philosofical level, higher the risk, higher the return, from that point I can agree common stock will have a higher return, but on practice I don`t see how.
If the company decides only to pay Preferred Stock and don`t pay the Common stocks the dividends, the only way I see the Common Stock having a higher total return is if its price appreciation is higher that the preferred stock price appreciation+dividends.
Let me give a example:
ex 1) The Common Stock is at $25 and the Preferred at $24, let`s say both of them have a 5 dollar price appreciation they would cost respectively $30 and $29 after this price appreciation, but what if the company give $1,5 as dividends to the Preferred Stock and not to the Common the total return of the preferred would be higher in this situation. (thus wouldnt be right to say common stock have a higher expected return)