How to value preferred stock
Beginner Stock Market Investing, Stock Market Investing Advice, Stock Valuation
Preferred stocks have some of the characteristics of both ordinary stocks and bonds which mean that they have to be valued slightly differently. It is true that if you own preferred stock, you own part of the company just as you would if you owned common stock. Your ownership will be proportional to the amount of stock that you own. However, you are also entitled to a fixed dividend payment much like the interest payment on a bond. These dividend payments can be at any periodical interval such as monthly or yearly and depend on the policies of the company. These dividends offer one method by which the value of a preferred share can be calculated.
Preference stock also has a one other differentiating feature from common stock in that there is a preferential claim on the assets of the company in the event of liquidation or winding up. This means that if the company goes bust, preferred stockholders are paid from the proceeds of liquidation after other preferential creditors but before common stockholders receive a payment. Of course, bondholders take priority before preferred stockholders in the event of liquidation. Similarly, if the Board is of the opinion that there are insufficient earnings to service a full dividend, the common stock dividend would be eliminated first.
Under normal circumstances, the future dividend payment on preferred stock can be accurately established and is normally expressed as a percentage of the price of the share or as a fixed dollar amount per share. Because preference stock generates consistent cash return much like a bond, the valuation can be accomplished by discounting these future cash flows to establish the present value. Because of the fixed dividend on preferred stock, unlike common stock where there is no fixed or guaranteed dividend, you can establish the cash flows in perpetuity and use the appropriate discount rate to calculate the present value.
The actual calculation is pretty straightforward as an example will illustrate. Let us say that you own preferred stock in a company which pays a fixed dividend of $.25 on a monthly basis, the value of the stock would be $50 using the dividend discount method and a discount rate of 6% per annum. This value is achieved by dividing the monthly dividend [$.25] by the monthly discount rate [0.05%). It is important that, in this calculation, every single future dividend payment is discounted back to the present value and then added together.
One factor to be taken into account in this valuation is that, though there is a guaranteed dividend, the payment can be reduced or eliminated altogether if the earnings are insufficient. This risk increases as the percentage of the dividend payment to the total earnings increases and has to be factored into the calculation. Another factor that needs to be taken into account is that preference stock normally does not include the voting rights associated with common stock. This may not be important to the average investor but could be a consideration if you own large blocks of preferred stock. The lack of voting rights could also affect the marketability of the stock when you wish to sell.
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