7.1: Common and Preferred Stock

Corporations raise equity capital by issuing ownership claims in the form of common stock and preferred stock. While both represent equity interests in the firm, they differ substantially in terms of cash flow rights, control, risk, and valuation. Understanding these differences is essential before applying equity valuation models later in this chapter.

Equity holders, unlike bondholders, do not receive contractually guaranteed payments. Instead, their returns depend on firm performance, dividend policy, and market expectations. As a result, equity valuation requires a clear understanding of how different equity securities generate cash flows.

Common Stock

Common stock represents the fundamental ownership interest in a corporation. Common shareholders are residual claimants, meaning they are entitled to the firm’s remaining cash flows only after all obligations to creditors and preferred shareholders have been satisfied. This residual position makes common stock riskier than other securities, but it also provides the greatest potential for long-term growth.

Key characteristics of common stock include:

• Ownership and control: Common shareholders typically have voting rights that allow them to elect the board of directors and vote on major corporate decisions.
• Dividends: Dividend payments are discretionary and determined by the board of directors. They are not contractual obligations.
• Capital appreciation: Investors may benefit from increases in stock price as the firm grows in profitability and market value.
• Residual claim: In liquidation, common shareholders are paid only after debt holders and preferred shareholders.

Real-World Example: Medline Inc. IPO Prospectus Cover

When a company issues common stock to the public for the first time through an initial public offering (IPO), key offering terms are summarized on the prospectus cover. This real-world artifact mirrors the bond prospectus supplement used in Chapter 6 and highlights how equity financing terms are disclosed to investors.

Real-World Example: Prospectus cover for Medline Inc. Class A common stock IPO. Source: U.S. Securities and Exchange Commission (EDGAR). Used for educational purposes.

TIP: When reviewing an IPO prospectus cover, focus on (1) the security type and share class, (2) the offering price and shares offered, and (3) the underwriting syndicate. These details provide early insight into ownership structure, expected proceeds, and market signaling.

Because dividends and prices are uncertain, the expected return on common stock is composed of two components:

Formula 7.1: Expected Return on Common Stock
\[ r = \text{Dividend Yield} + \text{Capital Gains Yield} \]

where:

• Dividend Yield \( = \frac{D_1}{P_0} \)
• Capital Gains Yield \( = g \), the expected growth rate of dividends and stock price

TIP: For common stock with stable growth, dividend growth and price growth move together. As a result, the expected capital gains yield equals the expected dividend growth rate.

This relationship highlights the direct connection between dividend growth and price appreciation for common stock investors.

Example 7.1A – Estimating the Expected Return on Common Stock

Suppose a stock is expected to pay a dividend of $2.00 next year, the current stock price is $40, and dividends are expected to grow at a constant rate of 5% per year.

\[ \text{Dividend Yield} = \frac{2.00}{40} = 0.05 = 5\% \]

\[ \text{Capital Gains Yield} = g = 5\% \]

\[ r = 5\% + 5\% = 10\% \]

This expected return reflects both current income from dividends and anticipated price appreciation driven by growth.

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Preferred Stock

Preferred stock is a hybrid security that combines features of both debt and equity. Like bonds, preferred stock typically provides a fixed dividend payment. Like common stock, it represents ownership and generally has no maturity date.

Common features of preferred stock include:

• Dividend priority: Preferred shareholders receive dividends before common shareholders.
• Fixed dividend: Dividends are usually stated as a percentage of par value.
• Limited control: Preferred shareholders typically do not have voting rights unless dividends are in arrears.
• Embedded features: Many preferred shares are callable or convertible into common stock.

Because preferred dividends are generally fixed and paid indefinitely, preferred stock valuation closely resembles the valuation of a perpetuity.

Valuing Preferred Stock

Formula 7.2: Preferred Stock Valuation
\[ P_0 = \frac{D_p}{r_p} \]

where:

• \( P_0 \) = intrinsic value of the preferred stock
• \( D_p \) = annual preferred dividend
• \( r_p \) = required rate of return on preferred stock

TIP: Preferred stock valuation is mathematically identical to a perpetuity. On a financial calculator, this can be solved using the perpetuity shortcut or as a very long annuity.

Example 7.1B – Valuing Preferred Stock

Assume a preferred stock pays an annual dividend of $6.00. If investors require an 8% return, the intrinsic value is:

\[ P_0 = \frac{6}{0.08} = 75.00 \]

Interpretation: If the preferred stock is priced below $75, it offers a return greater than 8%. If priced above $75, its expected return is less than 8%.

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Comparing Common and Preferred Stock

Feature	Common Stock	Preferred Stock
Ownership Rights	Voting rights; residual ownership	Limited or no voting rights
Dividends	Variable and discretionary	Fixed, typically stated as % of par
Priority in Liquidation	Paid last	Paid before common shareholders
Risk and Return	Higher risk, higher potential return	Lower risk, more stable return
Typical Valuation Model	Dividend discount or market-based models	Perpetuity model

This distinction between common and preferred stock establishes the foundation for the equity valuation models developed in the next section, beginning with dividend discount models for common stock.