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Preferred Stock Valuation: Methods & Calculations Video

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  • 0:04 Preferred Stock
  • 1:13 Dividend Discount Approach
  • 2:39 Call Provision
  • 3:10 The Gordon Growth Model
  • 4:20 Lesson Summary
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Lesson Transcript
Instructor: James Walsh

M.B.A. Veteran Business and Economics teacher at a number of community colleges and in the for profit sector.

Preferred stock combines aspects of both debt and equity investments. Its value comes from the dividend payments which are often fixed. We will illustrate two valuation models for preferred stock with examples and calculations.

Preferred Stock

Preferred stock is the hybrid of investments. It has aspects of both fixed income debt investments and common stock equity. It's like equity in that it provides ownership and it's like debt in that preferred dividends are like the interest payments debt holders receive. It's called preferred stock because preferred stockholders get preferential treatment when it comes to receiving their dividend. Preferred stockholders are paid after the bondholders but before the holders of common stock. So preferred stock is perceived to be less risky than common stock since there might not be anything left over after the preferred stockholders get paid.

Preferred stock may be safer than common stock, but that comes with a smaller reward. Preferred dividends typically pay a fixed dividend, meaning the dividends stay the same. They don't vary with how well the company does. Common stock, on the other hand, has a more flexible dividend, increasing when the company does well or skipped altogether when times are bad.

In this lesson, we're going to examine two ways in which preferred stock can be valued, the dividend discount approach, and the Gordon growth model.

Dividend Discount Approach

Fred is evaluating an investment in Big Blue Company preferred stock. They pay a fixed dividend, which, as you recall, means the dollar amount hasn't changed in years. The share price hasn't changed much either, but Fred isn't concerned about that. If he was looking for price appreciation he would buy Big Blue common stock. Instead, Fred just wants a stable, low-risk investment that he can use later to finance college for his kids.

Fred concludes that the value of this investment is the dividend since it will be paid before the common shareholders get anything. He can put a dollar value on it by using the dividend discount approach, which uses the traditional discounting formula to calculate the present value of the stream of dividend payments. It looks like this:

Preferred 2

where

D = Dividend

V = Value of the preferred stock

r = required rate of return

n = number of years

Since Fred is assuming that the dollar amount of the dividend will not change, he doesn't have to do all of that work. If the dividend is fixed he only needs to do this where r is his required rate of return. So for fixed dividends, the dividend discount model looks like this:

Dividend discount model
Preferred 2

So if Big Blue Company preferred stock pays a dividend of $20 per year, and Fred's required rate of return is 8%, the stock has a value of $20 / 0.08, or $250.

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