216 CHAPTER 5 Stocks and Their Valuation
Preferred Stock
Preferred stock is a hybrid—it is similar to bonds in some respects and to common
stock in others. The hybrid nature of preferred stock becomes apparent when we try
to classify it in relation to bonds and common stock. Like bonds, preferred stock has a
par value and a fixed amount of dividends that must be paid before dividends can be
paid on the common stock. However, if the preferred dividend is not earned, the
directors can omit (or “pass”) it without throwing the company into bankruptcy. So,
although preferred stock has a fixed payment like bonds, a failure to make this pay-
ment will not lead to bankruptcy.
As noted above, a preferred stock entitles its owners to regular, fixed dividend pay-
ments. If the payments last forever, the issue is a perpetuity whose value, Vp, is found
as follows:
(5-6)
Vpis the value of the preferred stock, Dpis the preferred dividend, and rpis the re-
quired rate of return. MicroDrive has preferred stock outstanding that pays a dividend
of $10 per year. If the required rate of return on this preferred stock is 10 percent,
then its value is $100, found by solving Equation 5-6 as follows:
If we know the current price of a preferred stock and its dividend, we can solve for the
rate of return as follows:
(5-6a)
Some preferred stocks have a stated maturity date, say, 50 years. If MicroDrive’s
preferred matured in 50 years, paid a $10 annual dividend, and had a required return
of 8 percent, then we could find its price as follows: Enter N 50, I 8, PMT 10,
and FV 100. Then press PV to find the price, Vp$124.47. If rpI 10%,
change I 8 to I 10, and find P VpPV $100. If you know the price of a share
of preferred stock, you can solve for I to find the expected rate of return,ˆrp.
Most preferred stocks pay dividends quarterly. This is true for MicroDrive, so we
could find the effective rate of return on its preferred stock (perpetual or maturing) as
follows:
If an investor wanted to compare the returns on MicroDrive’s bonds and its preferred
stock, it would be best to convert the nominal rates on each security to effective rates
and then compare these “equivalent annual rates.”
Explain the following statement: “Preferred stock is a hybrid security.”
Is the equation used to value preferred stock more like the one used to evaluate
a perpetual bond or the one used for common stock?
EFF%EARpa 1
rNom
m
b
m
1 a 1
0.10
4
b
4
1 10.38%.
rp
Dp
Vp
.
Vp
$10.00
0.10
$100.00.
Vp
Dp
rp
.
212 Stocks and Their Valuation
