APPENDIX 10-B THE ANALYSIS AND VALUATION OF PREFERRED STOCK
In Chapter 2 preferred stock was classified for investment analysis purposes as a fixed-income security, although technically it is an equity security. It is best described as a hybrid security, having some characteristics similar to fixed-income securities (i.e., bonds) and some similar to common stocks.
ANALYSIS
Preferred stock can be described as a perpetuity, or perpetual security, since it has no maturity date and will pay the indicated dividend forever. Although perpetual, many preferred stock issues carry a sinking fund, which provides for the retirement of the issue, usually over a period of many years. Furthermore, many preferred stocks are callable by the issuer, which also potentially limits the life of preferreds. Finally, roughly half of all preferred stocks issued in recent years are convertible into common stock. Therefore, although preferred stock is perpetual by definition, in reality many of the issues will not remain in existence in perpetuity.
Preferred stock dividends, unlike common stock dividends, are fixed when the stock is issued and do not change. These dividends are specified as an annual dollar amount (although paid quarterly) or as a percentage of par value, which is often either $25 or $100. The issuer can forgo paying the preferred dividend if earnings are insufficient. Although this dividend is specified, failure to pay it does not result in default of the obligation, as is the case with bonds. Most preferred issues have a cumulative feature, which requires that all unpaid preferred dividends must be paid before common stock dividends can be paid.
Investors regard preferred stock as less risky than common stock because the dividend is specified and must be paid before a common stock dividend can be paid. They regard preferreds as more risky than bonds, however, because bondholders have priority in being paid and in case of liquidation. Investors should, therefore, require higher rates of return on preferred stock than on bonds of the same issuer, but a smaller required return than on common stocks. A complicating factor in this scenario, however, is that 70 percent of dividends received by one corporation from another are excludable from corporate income taxes, making preferred stock an attractive investment for corporations. As a result of this tax feature, preferred stocks often carry slightly lower yields than bonds of comparable quality.
VALUATION
The value of any perpetuity can be calculated as follows:
C C
Vp = ------+ ------+ ... (10B-1)
(1 + kp) (1 + kp)2
C
= --
kp
where
Vp= the value of a perpetuity today
C = the constant annual payment to be received
kp= the required rate of return appropriate for this perpetuity
Because preferred stock is a perpetuity, Equation 10B-1 is applicable in its valuation. We simply substitute the preferred dividend (D) for C and the appropriate required return (kps) for kp, resulting in Equation 10B-2.
D
Vps = -- (10B-2)
kps
A preferred stock, or any perpetuity, is easy to value because the numerator of Equation 10B-2 is known and fixed, forever. No present value calculations are needed for a perpetuity, which simplifies the valuation process considerably. If any two of the values in 10B-2 are known, the third can easily be found.
As an example of the valuation analysis, consider the $1.59 preferred stock of Duke Energy. This $1.59 annual dividend is fixed. To value this preferred, investors need to estimate the required rate of return appropriate for a preferred stock with the degree of riskiness of Duke. Suppose the k, or required rate of return, is 7 percent. The value of this preferred would be
$1.59
VDuke = -----
0.07
= $22.71
On the other hand, a required rate of return of 10 percent would result in a value of $15.90.
If the current price for this preferred, as observed in the marketplace, is used in Equation 10B-2, the yield can be solved by using Equation 10B-3.
D
kps = --- (10B-3)
Pps
In the case of Duke Energy, the price at mid-March 2001 was about $25.25, indicating a yield, or required rate of return, of about 6.3 percent.
Notice from Equation 10B-2 that as the required rate of return rises, the price of the preferred stock declines; obviously, the converse is also true. Because the numerator is fixed, the value (price) of a preferred stock changes as the required rate of return changes. At the time of the price observation for Duke, the range for the preceding 52 weeks was $22 to $27. Clearly, investors' required rates of return fluctuate across time as interest rates and other factors change. As rates fluctuate, so do preferred stock prices.