Preferred Stock – Concept, Valuation, Features, Analysis, Formula & moreLast Updated Date: Nov 19, 2022
One of the easiest things to learn is determining the Value of a Preferred Stock.
The best way to understand is through the formula as there is no stress calculating or remembering the investment rules.
One of the best ways to learn about it is through seeing the financial scene and working through it.
About Preferred Stock
The preferred shares tend to have the features of both stocks and bonds that make the calculation part of these shares different from ordinary shares.
Ideally, preferred share’s owners are part of the company’s preparation to held shares, just like familiar stakeholders.
The preferred shares are a mix of securities which are a combination of common shares and bonds.
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Basics of Preferred Stock
Preferred stock is ideally a form of equity that is mainly useful for the expansion of projects or developments which the company is planning.
Just like equity capital, companies can sell preferred stocks to raise money. The best part about preferred stock is that it doesn’t dilute the ownership of stakeholders.
It is because the preferred stocks don’t have the same voting rights as common stocks.
When it comes to flexibility, it is similar to common equity and some debt instruments. As it shares some standard features of equity, so it is also known as equity.
The common elements of bonds and preferred shares include par value. At the same time, the common equity shares don’t feature par value.
Often companies raise funds by selling common or preferred stock. It is also known as preferred shares.
Just like the owners of the equity shares, the owners of the preferred reserve also have equal ownership rights.
Even though preferred stockholders don’t have the same voting rights as common stockholders, they have a priority when it comes to dividends and bankruptcy.
Ideally, this type of stock is also a hybrid tool having both equity and fixed income elements.
The hybrid aspect of the preferred stock makes them less risky as compared to common stock and it is due to stream of dividends.
In simple terms, you can say that it is a fantastic alternative for investors who don’t wish to take many risks by investing in equities.
The preferred share also has a callable feature that allows the stockholder to redeem it anytime for the cash value. Hence, it is an investor’s security.
Usually the preferred stockholders are given more priority when dividend payouts take. Above all, dividends are payable at a fixed rate.
Features of the Preferred Stock
The preferred shares are mainly different from common stocks because they have a preferential claim on the business’s assets.
When the company goes bankrupt, the preferred shareholders are mostly paid before familiar stakeholders.
Besides that, preferred shareholders get a fixed payment on monthly, quarterly, or yearly basis.
It all depends on the policy of the company and the valuation method. The dividend is the percentage of the stock price.
Difference between Preferred Stock, Common Stock and Debt
In a plethora of ways, the preferred stock is different from a common stock.
One of the thing which makes preferred stock different from common stock is that preferred shareholders are given more importance at the time of paying dividends.
You can also refer to it as a perpetuity, thanks to the nature of these preferred stocks. And for the same reason, the cost of the select stock formula is similar to the perpetuity formula.
Some of the most common types of stocks include preferred share and common stock. The individual rights of the preferred stock tend to vary from company to company.
The new board member’s voting rate is most likely to weigh in as all the common stocks tend to have a voting right. You can significantly influence the company if you own more amount of shares.
On the flip side, the preferred stocks don’t have any voting rights. Hence, it doesn’t matter how many shares you own; you won’t have any say in the business.
Even though the preferred stockholders don’t have a say in the company, but they tend to have a lot of priority in case of liquidation and dividend payments.
Hence, before common stockholders, the preferred shareholders get dividends. Furthermore, during bankruptcy, before common stockholders, these stockholders get the assets.
And if the company issues a bond, then before preferred stockholders, the bondholders will acquire the assets.
Cost of Preferred Stock
The cost of the preferred stock is the price that the company tends to pay for issuing the stock. In simple terms, it is the amount which the company pays in a year.
The amount is divided by the sum it receives from the issuance of shares. Often the management of the company uses the same metric to understand the way it raises capital.
The method is not only efficient but also useful. Companies can raise funds by issuing shares, debt, and preferred shares, and other instruments.
You can calculate the cost of preferred stock by dividing the annual preferred dividend by the market price of the claim.
After calculating the cost of preferred stock, you can compare the same with other financing options. You can also use the preferred stock to calculate the weighted average cost of capital.
Calculate Value of Preferred Stock
You can calculate the value of the preferred stock by dividing the fraction of dividends and the discount rate.
Additionally, you can use other characteristics, including a callable feature where the results tend to vary.
Ideally, that preferred shareholders get fixed dividends, and they are always given more priority as compared to the common stockholders.
The valuation of preferred stock considers the perpetuity factor. The value per share is calculated by dividing the annual dividend per share by the rate of return.
You can calculate the annual dividend per share by multiplying the face value of the claim with the rate of dividend.
The perpetuity factor takes place when fixed dividend payments have a similar characteristic as of preferred share.
You can say that value is equal to the present value of perpetuity if the preferred stock has a consistent rate of dividend growth.
The formula allows you to get a weighted annual dividend per share of preferred stock if you multiply the face value and dividend rate.
Above all, it gives you an accurate picture of the current situation prevailing in the stock market.
Thanks to the flexibility of the formula, which allows you to arrive at the correct value of a share of preferred shares in the company.
You can surely use the growth model if the dividend has a history of constant or predictable growth.
Here, p is the fair value of the share,
D1 is the expected dividend amount for the coming year.
R is the cost of equity or the rate of return.
G is the rate of growth of dividends.
For example a company has dividend earning of 25cent and rate of return is 6% per year.
V= $0.25/ 0.005= $50
Analysis of the Preferred Stock Valuation
The hybrid element of the preferred stock is less risky as compared to common stock. The majority of risk-averse investors consider it is an ideal option when it comes to investing in equities.
These stocks are preferred stocks because of their callable and convertible characteristics.
When investors run out of cash, the preferred stock is an ideal source of security. They can quickly redeem these stocks for the value of cash.
If you are planning to invest in preferred shares of any company, then you must ensure the company has positive returns.
For example, you can choose to invest in a company that pays more dividend rate as compared to the required rate of return.
Preferred Stock – Conclusion
Hence, preferred shares are more or less like equity investment which offers a steady stream of income besides potential appreciation; when it comes to calculating the value, you need to consider all the features.
Calculations featuring the discount dividend model are quite challenging because of the assumptions like the required rate of return or higher return length.
You can easily find the dividend payment, but it is challenging when the payment changes or has the potential to change in the future.
Also, it is challenging to find an excellent discount rate. On the flip side, if the number is off, then it changes the calculated value of shares significantly.
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