Subject 3. Preferred Stock Valuation

A preferred stock pays a fixed dividend for an infinite period. Thus, a preferred stock is a perpetuity since it has no maturity. Payments of preferred dividends are made only after the firm pays its bond interest. Thus,

where r is the required rate of return on preferred stock, and the dividend is assumed to be perpetual.

The basic types of preferred stock include:

  • Cumulative. The cumulative feature of a preferred stock means that if the company withholds any part of expected dividends, these payments are in arrears and must be settled before any other dividends. Most preferred stock carries this attribute.

  • Callable. This feature gives the issuer the right to redeem the stock at a date and price outlined in the prospectus. Most preferred stock is callable. This feature essentially reduces the value of the preferred stock.

    A retractable preferred share allows an investor to redeem the share whenever the investor wants. As a result, the value of the preferred share is increased.

  • Convertible. This is an option for the preferred stockholder to convert the shares into a fixed number of common shares at any point after a pre-determined date. While exchanges are initiated by the shareholder, there is sometimes a provision allowing the company to call for the conversion.

  • Participating. This attribute offers the investor the opportunity to earn a dividend beyond the stated rate as outlined in the prospectus. Most preferred stock is non-participating.

User Contributed Comments 4

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ratoncillo: Where is the formula?
GinnyB: ratoncillo: V = D/r
jonan203: FYI, preferreds typically have a $25 par value that is used to calculate the implied "coupon" rate.

$25 x .05 = $1.25 dividend
bravoshieh: With redeemable preferred shares, the issuer has the right to redeem the outstanding stock from the buyers at a specific price. Redeemable preferred shares are also referred to as callable preferred shares.
Retractable preferred shares give the buyer the right to sell the stock back to the issuer at a specific fixed price.