Valuation of Non-Callable, Non-Convertible Preferred Stock

Preferred Stock

Preferred stock shares characteristics with both debt and common equity.

• Issuer Profile – They represent a small fraction of total equity. They are typically issued by private companies, venture capital firms, or public companies in regulated sectors such as banks, insurance, and utilities.
• Claims Priority – Although preferred dividends are not legally binding contracts, preferred shareholders retain a priority claim over common equity for both dividend distributions and asset liquidation.
• Cash Flows – Preferred stock typically pays a fixed periodic dividend based on a percentage of its par value.

As preferred stock pays fixed dividends, it is valued using a Dividend Discount Model (DDM) with a few modifications. Additionally, Preferred stock carries less risk than common stock; its required return is lower, that is \((r_p \lt r_e)\).

Finite-Life Preferred Stock

Preferred stock with a finite life is calculated as:

$$IV_t = \sum_{i=1}^{n} \frac{D}{(1+r_p)^i} + \frac{FV}{(1+r_p)^n}$$

Where:

• \(D\) – Fixed preferred dividend
• \(FV\) – Face/par value repaid at maturity
• \(r_p\) – Required return on preferred stock

Perpetual Preferred Stock

Perpetual preferred stock is calculated as:

$$IV_t = \frac{D}{r_p}$$

• \(D\) – Fixed preferred dividend
• \(r_p\) – Required return on preferred stock

Example 1: Intrinsic Value of the Preferred Share

Suppose a preferred share has the following characteristics:

• Par value \((FV) = \$100\)
• Annual dividend rate \(= 6\%\)
• Annual preferred dividend \((D) = 6\% \times \$100 = \$6\)
• Required return \((r_p) = 5\%\)
• Years to maturity \((n) = 5\text{ years}\)

The intrinsic value of the preferred share can be calculated as:

Preferred stock with a finite life is calculated as:

$$ \begin{align*} IV_t & = \sum_{i=1}^{n} \frac{D}{(1+r_p)^i} + \frac{FV}{(1+r_p)^n} \\
IV_t & = \frac{6}{(1.05)^1} + \frac{6}{(1.05)^2} + \frac{6}{(1.05)^3} + \frac{6}{(1.05)^4} + \frac{6}{(1.05)^5} + \frac{100}{(1.05)^5} = 104.32 \end{align*}$$

Contingency Features & Valuation Impacts

Contingency features give either the issuer or the investor the right, but not the obligation, to alter the shares. These embedded options directly affect the security’s value.

Callable Preferred Shares

• The issuer has the right to redeem the shares before maturity at a predetermined price.
• This reduces the value to the investor. Issuers must offer a higher dividend rate to compensate investors for the risk that the shares may be called away.

Putable preferred shares

• The investor has the right to sell the shares back to the issuer at a predetermined price.
• Increases value to the investor. This protects the investor, and the shares generally carry a lower dividend rate.

Convertible preferred shares

• The investor has the right to exchange preferred shares for common shares at a fixed ratio.
• This feature makes the shares highly attractive to early stage/VC investors. It blends debt-like downside protection (senior claims) with equity-like upside potential.

Question

What is the intrinsic value \((IV_t)\) of a perpetual preferred stock that pays a fixed annual dividend of $6 when the required rate of return is 5%?

1. $30.00
2. $100.00
3. $120.00

The correct answer is C.

The intrinsic value of perpetual preferred stock is calculated using the formula:

$$ IV_t= \frac{D}{r_p} $$

Given:

• Fixed preferred dividend \((D) = $6\).
• Required return \(r_p = 5\%\)
  
  $$ IV_t= \frac {$6}{5\%}=\$120 $$

The intrinsic value is $120.00.