Valuation of Preferred Stock - Financial Management

Most preferred stock pays regular, fixed dividends. Preferred dividends per share are normally not increased when the earnings of a firm increase, nor are they cut or suspended unless the firm faces serious financial problems. If preferred stock dividends are cut or suspended for a period of time for whatever reason, the firm is usually required to make up the past-due payments before paying any common stock dividends. Thus, the investor’s expected cash return from holding most preferred stocks can be treated as a fixed, constant amount per period.

The investor’s required rate of return on a preferred stock issue is a function of the risk that the firm will be unable to meet its dividend payments. The higher the risk, the higher the required rate of return. Because bondholders have a prior claim over preferred stockholders on the income and assets of a firm, it is more risky to hold a firm’s preferred stock than to hold its bonds.As a result, investors normally require a higher rate of return on preferred stock than on bonds.

Because many preferred stock issues do not have maturity dates, the cash flows from holding no -maturity preferred stock can be treated as a perpetual stream of payments, or a perpetuity. Capitalizing the perpetual stream of dividend payments gives the following valuation expression:

where Dp is the dividend per period, and kp is the investor’s required rate of return. Like the perpetual bond valuation model, this equation can be simplified into the following valuation model:

P0 = Dp/kp

To illustrate the use of Equation , assume that DuPont pays annual end -of -year dividends on its $4.50 series B cumulative preferred stock issue (issue price$100, par value of $0).What is the value of this stock to an investor who requires an 8 percent annual rate of return on the investment? Assume that the issue will not be called for the foreseeable future. Substituting$4.50 (0.045*$100) for Dp and 0.08 for kp yields the following: P0 =$4.50/0.08 = \$56.25