The Foundation
5.8 Preferred Stock Features and Valuation
Preferred stock is a hybrid security combining features of debt and common stock. From a legal and tax standpoint, preferred stock is a form of equity, which has preference over common stock in the payment of dividends and in the distribution of assets in the event of liquidation. Nevertheless, a good case exists to think of preferred stock as being debt in disguise. Preferred stock is similar to debt in that both securities generally have fixed pay- ments. Preferred stock is similar to common stock in that most preferred issues have no maturity. Unlike common stockholders, preferred stockholders typically do not have voting rights or share in the residual earnings of the company. Exceptions exist to these general characteristics of preferred stock.
Preferred Stock Features
We discuss common characteristics and features of preferred stock below.
Par or no par stock
Similar to a bond, preferred stock typically has a stated par value, such as $25 or $100, which represents the size of the claim the preferred stockholders have in the event of bank- ruptcy. No par preferred stock has no par value and no specific per share liquidation claim.
No maturity date
Corporations usually intend to use preferred stock as a permanent part of their equity.
Hence, most preferred stocks have no maturity date. Some issues, however, have specified maturities. Others have a sinking fund feature, which effectively creates a final maturity.
Dividends
Preferred stock typically carries a stipulated dividend that the issuer pays on a quarterly basis. Dividends are stated as a percentage of the par value or as a fixed amount for no par stock. Some preferred stock issues, called adjustable rate, variable rate, or floating rate preferred, do not have a fixed dividend, but peg dividends to an underlying index such as the rate on Treasury securities or other money market rates. Unlike interest payments on debt, preferred stock dividends are not a legal obligation of the firm. A corporation has no fixed obligation to pay dividends if it has insufficient earnings. Omitting the dividend will not result in a default of the obligation or force the firm into bankruptcy. From the issuer’s perspective, preferred stock is less risky than bonds.
Cumulative feature
Most preferred stocks have a cumulative feature, requiring the company to pay all cumulative unpaid preferred dividends before resuming paying any dividends on common stock. Late or overdue dividends are arrearages. Many preferred stocks incur arrearages for a limited period, such as 3 years. Unpaid preferred dividends do not represent an obligation to the firm. If the corporation fails to pay a dividend on noncumulative preferred stock, investors generally lose this dividend.
Claims on assets and income
Preferred stockholders have a priority claim over common stockholders in the liquidation of assets resulting from bankruptcy. The basis of the amount of payment made to preferred stockholders is the par value or the liquidation value of the preferred stock. The liquidation value is the maximum amount that investors will receive at liquidation. Preferred stock- holders also have a priority of claim to dividends before common stockholders do. Because of their prior claim on assets and income, preferred stockholders typically have no voting rights, except in special situations such as the company’s inability to pay dividends for a specific period. From the perspective of investors, preferred stock is riskier than debt because creditors have a prior claim on assets and income.
Retirement of preferred stock
Similar to bond issues, preferred stock issues almost invariably have provisions for retire- ment. For example, almost all preferred stock issues have a call provision, which gives the issuer flexibility in retiring the issue. Many preferred stock issues also have sinking funds to facilitate the orderly retirement of the stock. Some preferred stock issues are convertible, which gives the holder the option to exchange preferred stock for common stock under certain conditions. Upon conversion, the corporation retires the preferred stock.
Preferred Stock Valuation
The valuation of preferred stock is relatively simple if the firm pays fixed dividends at the end of each year. If this condition holds, the stream of dividend payments represents a
138 THEFOUNDATION
perpetuity discounted at the investor’s required rate of return. For such preferred stock, the following perpetuity formula (discussed in Chapter 4) applies.
V D
p k
p pt t
= +
∑
∞ ( )=1 1
(5.12)
where Vp is the value of a share of preferred stock; Dp is the expected dividends per share on preferred stock; kp is the investor’s required rate of return on preferred stock; t is the time period; and ∞ is infinity.
Equation 5.12 says that the intrinsic value of preferred stock is the present value of all the preferred stock dividends to infinity. We can simplify this equation as follows.
V D
p k
p p
= (5.13)
Equation 5.13 computes the intrinsic value by capitalizing a perpetual stream of divi- dends. The difficult task in applying Equation 5.12 and 5.13 is estimating the required rate of return.
Example 5.15 Preferred Stock Valuation
Suppose Potomac Corporation has a $100 par value preferred stock that pays an annual dividend of $7. If investors require an 8 percent return on this preferred stock, what should be its intrinsic value?
Solution: Substituting Dp = $7 and kp = 0.08 into Equation 5.13 results in an intrinsic value of:
Vp= $ =$ . .
7
0 08 87 50
Investors interpret the results of preferred stock valuation in the same way that they do for bonds. That is, if the estimated value is greater than or equal to the current market price, say $85 a share, investors would consider buying the preferred stock.
If the estimated value is less than the market price, they would decide against a purchase, or they would consider selling if they owned the stock. The formula for evaluating maturing preferred stock is identical in form to the bond value formula.
Practical Financial Tip 5.8
For a US corporation with both bonds and preferred stock, preferred stock has a lower before-tax yield than bonds due to the partial tax exclusion on dividends for corporate investors. However, the after-tax yield on the preferred is typically higher than on the firm’s highest-grade bonds.
Expected Return on Preferred Stock
Determining the expected rate of return, also called a promised yield, on preferred stock simply involves dividing the annual dividend by the current market price.
ˆ
k D
p P
p p
= (5.14)
where kˆp is the expected rate of return on a preferred stock; Dp is the annual cash dividend on preferred stock; and Pp is the current market price on preferred stock. Here, kˆp (called “kp
hat”) is the expected rate of return, as opposed to kp, which represents the required rate of return.
Example 5.16 Expected Rate of Return of Preferred Stock
Assume the current market price of Potomac Corporation’s preferred stock is $85, what would be the expected rate of return? If an investor’s required rate of return is 8 percent, should the investor consider buying the preferred stock?
Solution: Using Equation 5.14, the expected rate of return on the preferred stock is:
ˆ . %
kp= $ =
$ 7 85 8 24
Since the expected rate of return of 8.24 percent is greater than the required rate of return of 8 percent, the investor should consider buying the stock. The buy/
sell decision using the expected rate of return criterion always agrees with the deci- sion derived by comparing the intrinsic value of the preferred stock to its market price.
140 THEFOUNDATION
Concept Check 5.8
1 Why is preferred stock a hybrid security?
2 What is the importance of a cumulative dividend feature to preferred stockholders?
3 What are the components in valuing a preferred stock?
4 Is the after-tax yield on a preferred stock typically higher or lower than the after-tax yield on the firm’s highest grade bonds? Why?