Overview
In this article, we will cover all aspect of preferred stock including its types, valuation of preferred stock and example.
Company issue their stocks or shares in the stock market that common public or other companies can buy to become the owner of the company. They are also called shareholders of the company. When these shareholders buy the stocks of the company, they are given part ownership of the company based on the number of shares of the company they own. These shares also come with voting rights that allow the shareholders to contribute to the decision-making process of the company.
The most common type of stock of a company that is widely traded and available in the stock market is the ordinary shares of the company, also known as common shares. These shares are issued by a company to raise finance. The ordinary shares of a company give its shareholders voting rights according to the fraction of their holding, the right to elect the board of directors of the company and the right to dividends paid from the earnings of the company. The common shares of the company outperform other types of stocks of the company in the long-term.
However, in case the company is liquidated, the ordinary shares of the company are last to be compensated. This means, in case of liquidation, all other obligations of the company are paid first and any remaining assets are distributed among the ordinary shareholders of the company. Furthermore, while the ordinary shares come with a right to dividends, these dividends are paid at last after all the expenses of the company have been paid off first. This also means that if the company’s expenses exceed its earnings, or in simpler words, the company has made a loss, the ordinary shareholders aren’t paid any dividend.
Due to the above risks associated with the company’s ordinary shares, some investors may hold back on investing in the company. Therefore, to tackle these risks, the company may choose to issue another type of stock. These types of stocks are known as Preferred Stocks.
Before we jump to the valuation model of preferred stock, let’s understand some key definition and different types of preferred stock.
What is Preferred Stock?
The Preferred Stock of the company, also known as Preference Shares, are shares issued by the company that gives its shareholders a preference over the common shareholders of the company. This preference comes in the form of being paid dividends before the common shareholders of the company, some times regardless of whether the company makes a profit or not. Most preferred stocks have a fixed dividend unlike common stocks of the company.
Similarly, the preferred stockholders are also preferred when the company is liquidated. This means in case of liquidation, the preferred stockholders of compensated first, before other stockholders. These features of the preferred stock make the stock more attractive to any risk-averse potential investors than the common stock of a company.
The preferred stock of a company may also come with some disadvantages. For investors, the preferred stock does not come with any voting rights. This means that the preferred stockholders of the company do not have the right to participate in the decision-making process of a company. Furthermore, while the preferred stockholders are guaranteed a fixed dividend rate, which is advantageous when the company is not making a lot of profits or is in a loss, it may be disadvantageous when the company is making huge profits. This means that when the company’s earnings increase significantly, the common stockholders of the company will receive more dividends than the fixed dividends paid to preferred stockholders.
Types of Preferred Stock
There are 4 main types of preferred stock. Theses types are convertible preferred stock, cumulative preferred stock, participating preferred stock and redeemable preferred stock.
Convertible Preferred Stock
Convertible preferred stock is the type of preferred stock that provides the stockholders with the option to convert their preferred stock into common shares on maturity. The company may also impose conditions on convertible preferred stock that allows it to force the conversion regardless of whether the investor want to convert or not.
Convertible preferred stocks are converted based on a pre-determined ratio. For example, the company may give 1 common share for every 2 preferred stocks held by the investor. The company may also convert the shares based on the value of the preferred stock. For example, the company may give 2 common shares for every $100 of preferred stock held by the investor.
Convertible shares are generally beneficial to take up when, at the date of maturity, the market price of the common stock of the company exceeds the market value of the convertible preferred stock. This means that the investors will make a profit by converting their preferred stock to common stock. However, if the market value of the common stock is lower than the market value of the preferred stock, the conversion may not be worthwhile.
Cumulative Preferred Stock
Cumulative preferred stock is the type of preferred stock that come with a fixed dividend rate that is payable to the investors. However, if the company is unable to pay dividends, the dividends are aggregated and paid to the preferred stockholders before dividends are paid to the common stockholders, once the company generates earnings.
For example, a company ABC Co. issued cumulative preferred stocks with a fixed dividend of $100. The company was able to pay the preferred stockholders $100 after the first year of stock issuance. However, this company was not able to pay dividends to its stockholders in the second and third year because the company did not generate any profits. For the fourth year, the company generated profits. Therefore, before distributing these profits among common stockholders, ABC Co. must pay $300 ($100 x 3 years) to the preferred stockholders first.
Cumulative preferred stocks are a safer option for investors as the investors receive a fixed dividend and their dividends are preferred over common stock dividends. This makes cumulative preferred stock attractive to risk-averse investors. Cumulative preferred stocks are also safer for companies as they don’t have to pay dividends to the preferred stockholders if they don’t have any earnings.
Participating Preferred Stock
Participating preferred stock allows the preferred stockholders to participate in the earnings of the company along with a fixed dividend rate. This allows the stockholders to benefit from both a fixed dividend and a percentage of the earnings of the company paid to them as dividends. However, these profits are shared with the participating preferred stockholders only if the common stockholders are given dividends more than a pre-determined percentage. Any incremental payment to common stockholders above the pre-determined limit is shared equally with preferred stockholders.
Participating preferred stock does not provide the company with any advantages. These stocks are very rarely offered by the companies. Often times, companies issue participating preferred stock to discourage investment in the company because these stocks are not attractive to potential shareholders. This is mostly used when a company wants to block a takeover of the company.
Participating preferred are very attractive to investors as it provides them a guaranteed fixed income with the additional benefit of a participation in the profits of the company. If the company is liquidated, the participating preferred stockholder not only get their consideration for the stock first but also get a portion of the remaining value of the company’s net assets after all other liabilities are paid, sharing it with the common stakeholders.
Redeemable Preferred Stock
Redeemable preferred stock, also known as callable preferred stock, is the type of preferred stock that allows the company, that is issuing the stock, to redeem or call the stocks. This means that the issuing company has the option to convert the stock into common stock of the company. The conversion is done based on a pre-determined percentage or rate.
When preference shares are not redeemed, the company pays the stockholders the preferred stockholders for the value of the preferred stock and also pays a premium along with the value. This can be beneficial for investors as it give them a form of return for the risk they are taking.
Redeemable preferred stocks are the most common type of preferred stock issued by companies. This type of preferred stock is more beneficial to the company as it allows them with more control regarding the stock. The company may choose to convert these shares when the market value of the common shares is lower than the market value of the preference shares. The company can also choose to convert if it does not want to deplete its cash resources or does not have enough cash resources to repay the preferred stockholders.
Other Types
While the above are the main types of preferred stock, there are other types of preferred stock as well. Perpetual preferred stock is the type of preferred stock that never matures. A fixed dividend is paid, at preference, to the holders of perpetual preferred stock. The amount that the stockholders initially pay the company is never returned to the stockholders.
Prior preferred stocks are preferred stock that are given priority over other preferred stocks. For example, if a company issues more than one type of preferred stock, prior preferred stocks will have priority over all the other types of stocks. This means that prior preferred stockholders will receive dividends before other preferred stock holders and will also be compensated before them in case of company liquidation.
Retractable preferred stocks are preferred stocks that give the stockholder the option to choose whether to covert their shares into common shares or not redeem them. These are the opposite of redeemable preferred stock. The issuing company cannot block or dictate whether the retractable stocks are redeemed or not.
Preferred Stock Valuation Model
The valuation of a preferred stock with a fixed dividend can be determined by discounting the cashflows from the preferred stock to their present value. Since the dividends and the date of maturity of the preferred stock is fixed, the value can be calculated into perpetuity. Therefore, the formula to calculate the value of preferred stock can be written as:
Value per stock of Preferred Stock = Annual Dividend per Share / Rate of Return
However, if the preferred stock has a growing dividend rate, then this model cannot be used. Instead the Gordon Growth Model can be used to calculate the valuation of the preferred stock. The formula to calculate the value of preferred stock using the Gordon Growth Model is similar to the above formula but also considers the growth of dividends. The formula can be written as:
Value per stock of Preferred Stock = Annual Dividend per Share / (Rate of Return – Expected Growth Rate)
Example
A company, ABC Co. issues preferred with fixed dividend of $5 per preferred stock per annum. The annual rate of return of the company is 10%. The valuation of the preferred stock can be calculated using the following formula:
Value per stock of Preferred Stock = Annual Dividend per Share / Rate of Return
Value per stock of Preferred Stock = $5 / 10%
Value per stock of Preferred Stock = $50
Similarly, if the company issues preferred stock with a dividend of $5 that will grow by 2% each year, the value of the preferred stock can be calculated using the Gordon Growth Model. The formula for the model is as follows:
Value per stock of Preferred Stock = Annual Dividend per Share / (Rate of Return – Expected Growth Rate)
Value per stock of Preferred Stock = $5 / (10% – 8%)
Value per stock of Preferred Stock = $5 / 8%
Value per stock of Preferred Stock = $62.5
As apparent from the calculation, the value of preferred stock with a growing dividend over time will be greater than the value of preferred stock with a fixed dividend. However, mostly companies issue preferred stock with a fixed dividend rather than growing dividends.
Conclusion
Preferred stock is a type of stock that companies issue that has preference over common stocks of the company. There are many types of preferred stock that a company may issue. These include convertible preferred stock, cumulative preferred stock, participating preferred stock, redeemable preferred stock as the main types but may also include other types. The valuation of Preferred stock can be valued by using two models depending on whether the dividends paid on the preferred stock are fixed or are expected to grow in the future.
