Preferred Stock Valuation

Peferred stock is defined as equity with priority over common stock with respect to the payment of dividends and the distribution of assets in a liquidation. Preferred stock is a hybrid security which shares features with both common stock and debt.

Preferred stock is similar to common stock in that it entitles its owners to receive dividends which the firm must pay out of after-tax income. Moreover, the use of preferred stock as a source of financing does not increase the probability of bankruptcy for the firm.

However, like the coupon payments on debt, the dividends on preferred stock are generally fixed. Also, the claims of the preferred stockholders against the assets of the firm are fixed as are the claims of the debtholders.

Preferred stock has the following features:

Par Value

The par value represents the claim of the preferred stockholder against the value of the firm.

Preferred Dividend / Preferred Dividend Rate

The preferred dividend rate is expressed as a percentage of the par value of the preferred stock. The annual preferred dividend is determined by multiplying the preferred dividend rate times the par value of the preferred stock.

Since the preferred dividends are generally fixed, preferred stock can be valued as a constant growth stock with a dividend growth rate equal to zero. Thus, the price of a share of preferred stock can be determined using the following equation:

where

• P_p = the preferred stock price,
• D_p = the preferred dividend, and
• r = the required return on the stock.