PARt 2: VALUAtIoN, RISk ANd REtURN
In other respects, preferred shares look more like equity than debt. Dividends on preferred and
ordinary shares are not a tax-deductible expense for the company, but interest payments on debt
are deductible.^2 Preferred shareholders hold a claim that is junior to bonds, meaning that preferred
shareholders hold a lower-priority claim than bondholders, and they cannot take a company to court
for failure to pay dividends. Finally, many preferred shares do not have a specific maturity date and can
remain outstanding indefinitely, similar to ordinary shares.
Despite the differences among bonds, preferred shares and ordinary shares, analysts use some
of the same methods to value all of these securities. The most basic valuation methods rely on the
discounted cash flow techniques introduced in Chapter 3 and applied to bond valuation in Chapter- In the next section, we shall see how to use discounted cash flow methods to value preferred and
ordinary shares.
CONCEPT REVIEW QUESTIONS 5-1
1 How do you think preferred shares compare to bonds and ordinary shares in terms of the risks that
investors must face and the rewards that they expect?5-2 VALUING PREFERREd ANd
oRdINARY SHARES
The principles involved in valuing shares mirror those we adopted to determine bond prices in Chapter
- First, we estimate the cash flows that a shareholder expects to receive over time. Unlike bonds,
preferred and ordinary shares have no definite maturity date, so estimates of the cash flows going
to shareholders must necessarily take a long-term view. Second, we determine a discount rate that
reflects the risk of those cash flows. In the case of a bond, the discount rate is relatively easy to find.
You simply use the yield to maturity (YTM), which is the discount rate that equates the bond’s cash
flows to its market price, for a similar-risk bond. Because the cash flows provided by ordinary shares
are uncertain and the maturity date is undefined, there is no mechanical calculation equivalent to
a bond’s YTM that can provide a precise figure for the required return on a share – it has to be
estimated by some other means. Third, despite the difficulties just noted, we estimate the share’s price
by calculating the present value of its expected future cash flows. In other words, valuing shares is
simply another application of Equation 4.1 (see page 122).
5-2a PREFERREd SHARE VALUAtIoN
Preferred shares typically offer a fixed stream of cash flows with no specific maturity date. For that
reason, we can treat a preferred share as a security that behaves like a simple perpetuity. In Chapter 3,
you learned a shortcut for valuing a perpetuity. For a perpetuity that makes annual cash payments, with
the first payment arriving in one year, the present value equals the next payment divided by the discount2 In the US, the dividends on some kinds of ‘trust preferred shares’ are tax deductible for the company.LO5.2