11.5: Preferred Stock

Learning Objectives

By the end of this section, you will be able to:

• Define preferred stock.
• Calculate the intrinsic value of preferred stock.
• Understand the difference between common stock and preferred stock.

Features of Preferred Stock

Preferred stock is a unique form of equity sold by some firms that offers preferential claims in ownership. Preferred stock will often feature a dividend that a company is obligated to pay out before it makes any dividend payments to common stockholders. In cases of bankruptcy and liquidation of the issuing company, preferred stockholders have priority claim to assets before common stockholders. Additionally, preferred stockholders are usually entitled to a set (or constant) dividend every period.

Preferred stock carries a stated par value, but unlike bonds, they have no maturity date, and consequently, there is no final payment of the par value. The only time a company would pay this par value to the shareholder would be if the company ceased operations or retired the preferred stock. Many preferred stock issues are cumulative in nature, meaning that if a company skips or is otherwise unable to pay a cash dividend, it becomes a liability to the company and must eventually be paid out to preferred shareholders at some point in the future. Other preferred stocks may be noncumulative, in which case if the company skips dividends, they are forever lost to the shareholder.

The term preferred comes from preferred shareholders receiving all past (if cumulative) and present dividends before common shareholders receive any cash dividends. In other words, preferred shareholders’ dividend claims are given preferential treatment over those of common shareholders. Preferred stock is usually a form of permanent funding, but there are circumstances or covenants that could alter the payoff stream.

For example, a company may convert preferred stock into common stock at a preset point in the future. It is not uncommon for companies to issue preferred stock that has a conversion feature. Such conversion features give preferred shareholders the right to convert to common shares after a predetermined period.

A review of the characteristics of preferred stock will lead to the conclusion that the constant growth dividend model is an excellent approach for valuing such stock. Because shares of preferred stock provide a constant cash dividend based on original par value and the stated dividend rate, these may be considered a form of perpetuity.

It is this constant, preferred dividend stream that makes preferred stock seem more like bonds or another form of debt than like stock. In addition, the constant dividend stream leads nicely to the pricing of preferred stock with the four dividend models we presented earlier in this chapter.

Determining the Intrinsic Value of Preferred Stock

We can apply a version of the present value of a perpetuity formula to value preferred stock, as in the following example. Oh-Well Heath Services Inc. has issued preferred stock that has a par value of $1,000 and pays an annual dividend rate of 5%. If the market considers the risk of Oh-Well to warrant a 10% discount rate, what would be a fair market price for Oh-Well preferred stock?

First, we find the dividend value of Oh-Well:

\[\begin{aligned}\text{Dividend Dollar Value} &= \text{Par Value} \times \text{Annual Dividend Rate} \\[4pt]
& =\$ 1,000 \times 0.05 \\[4pt]
& =\$ \end{aligned}\]

We then use the constant dividend model with infinite horizon because we have g equal to zero and n equal to infinity::

\[\begin{aligned}
\text { Stock Value } & =\frac{\text { Dividend }}{\text { Discount Rate }} \\[4pt]
& =\frac{\$ 50}{0.10} \\[4pt]
& =\$
\end{aligned}\]

We can also rearrange the formula to determine the required return on this stock, given its annual dividend and current price.

Think It Through: Calculating the Return on Preferred Stock

Data Forge Inc. has just issued preferred stock (cumulative) with a par value of $100.00 and an annual dividend rate of 7%. The preferred stock is currently selling for $35.00 per share. What is the yield or return on this preferred stock?

Solution

The first step is to determine the annual dividend by multiplying the dividend rate by the par value:

$$\begin{array}{rcl}\$100\times 0.07& =& \$7.00\end{array}$$

11.53

Now, using this $7.00 annual dividend, the $35.00 current price, and the equation above, we calculate the rate of return as follows:

\[r=\frac{\$ 7.00}{\$ 35.00}=0.20 \text { or } 20 \% \tag{11.54}\]

We have introduced the concept of return here, which should be thought of as both the anticipated return for the preferred stockholder and the company’s cost of borrowing money for this particular type of capital.

Differences between Preferred and Common Stock

As we have discussed, preferred stock has important differences from common stock that apply to issuing firms and to investors. Some of the most important of these differences are listed in Table 11.7.

Table 11.7: Differences between Common Stock and Preferred Stock

Feature	Common Stock	Preferred Stock
Dividends	Paid only after preferred stockholders are paid	Highest priority, paid first
Dividends	Variable and may increase or decrease	Predetermined rates, so constant dividend amounts
Growth	High potential but tied to company performance
Liquidation	Paid out last, after all creditors and preferred stockholders are paid	Given preference in terms of payments, similar to bonds
Voting Rights	Yes	No
Arrears	No accrual of missed dividends	If cumulative, unpaid dividends become liability that must be paid out eventually
Certainty	Dividends potentially not paid if company earns no profits	Dividends paid even when company experiences financial losses