Preferred shares have the qualities of a stock and a bond, which makes valuation a little different than a common share. The owner of the preferred share is part owner of the company, just like a common shareholder. The stake in the company is in proportion to the held stocks. Also, there is a fixed payment which is similar to a bond issued by the company. The fixed payment is in the form of a dividend and will be the basis of the valuation method for a preferred share. These payments could come quarterly, monthly or yearly, depending on the policy stated by the company.
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Unique Features of Preferred Stock
Preferred shares also differ from common shares, in that they have preferential claim on the assets of the company. In the event of a bankruptcy, the preferred shareholders get paid first, over the common shareholders.
The creditors, or bond holders, trump both the common and the preferred shares in an instance like this. This also goes for dividend payments; in the event that the management of the company has determined that the earnings cannot support a full dividend payment, the common shares get cut first. (For a deeper look into preferred stocks, read A Primer on Preferred Stocks.)
Generally, the dividend is predictable and fixed as a percentage of the share price, or as a dollar amount. This is usually a steady predictable stream of income. When an investment pays a steady stream of payments, like some bonds or annuities, the valuation can be completed by discounting each cash flow back to today.
Preferred stocks have a fixed dividend, which means we can calculate the value by discounting each of these payments to the present day. This fixed dividend is not guaranteed in common shares. If you take these payments and calculate the sum of the present values into perpetuity, you will find the value of the stock.
For example, if ABC Company pays a 25 cent dividend every month and the required rate of return is 6% per year, then the expected value of the stock, using the dividend discount approach, would be $0.25/0.005 = $50. The discount rate was divided by 12 to get 0.005, but you could also use the yearly dividend of (0.25*12) $3 and divided it by the yearly discount rate of 0.06 to get $50. The point is that each issued dividend payment in the future needs to be discounted back to the present and each value is then added together.
V = the value
D1 = the dividend next period
r = the required rate of return
Because every dividend is the same we can reduce this equation down to:
Although the preferred shares give a dividend, which is usually guaranteed, the payment can be cut if there are not enough earnings to accommodate a distribution. This risk of a cut payment needs to be accounted for. This risk increases as the payout ratio (dividend payment compared to earnings) gets higher. Also, if the dividend has a chance of growing, the value of the shares will be higher than the result of the constant dividend calculation, given above.
Preferred shares usually lack the voting rights of common shares. This might be a valuable feature to individuals who own large amounts of shares, but for the average investor this voting right does not have much value. However, it still needs to be accounted for when evaluating the marketability of preferred shares.
Preferred shares have an implied value similar to a bond. This means the value will also move inversely with interest rates. When the interest rate goes up, the value of the preferred shares will go down, holding everything else constant. This is to account for other investment opportunities and is reflected in the discount rate used.
If the preferred shares are callable, the company gains a benefit and the purchaser should pay less, compared to if there was no call provision. The call provision allows the company to basically take the shares off of the market at a predetermined price. A company might add to this if the current market interest rates are high, requiring a higher dividend payment, and the company expects the interest rates to go down. This is a benefit to the issuing company, because they can essentially issue new shares at a lower dividend payment. (Due to their lowered price, callable shares pose risk: read Bond Call Features: Don't Get Caught Off Guard.)
If the dividend has a history of predictable growth, or the company states a constant growth will occur, you need to account for this. The calculation is known as the Gordon Growth Model.
Where the added g is the growth of the payments.
By subtracting the growth number, the cash flows are discounted by a lower number resulting in a higher value.
The Bottom Line
Preferred shares are a type of equity investment, which provide a steady stream of income and potential appreciation. Both of these features need to be taken into account when attempting to determine value. Calculations using the dividend discount model are difficult because of the assumptions involved, such as the required rate or return, growth or length of higher returns.
The dividend payment is usually easy to find, the difficult part comes when this payment is changing or potentially could change in the future. Also, finding a proper discount rate is very difficult and if this is off, it could drastically change the calculated value of the shares. When it comes to homework, these numbers will be simply given, but in the real world we are left to estimate the discount rate or pay a company to do the calculation.
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