Valuing preferred stock, and how call, put and conversion features change value

What makes preferred stock different?

Preferred stock pays a fixed dividend, a set percentage of its par value, like a bond’s coupon. It ranks ahead of common shares for dividends and for assets if the company is wound up: a priority claim . Unlike interest, preferred dividends are not a contractual obligation.

It is a small part of all equity outstanding, issued mostly by large public companies in regulated sectors (banks, insurers, utilities), by private companies and in venture capital deals.

Preferred shares may also have cumulative dividends (missed dividends must be paid before common dividends) or participating dividends (an extra share in profits), as well as call, put or conversion rights. These cumulative and participating dividends are only named here; Learning Module 1 defines them. This lesson values the plain case: non-callable, non-convertible, with a constant fixed dividend.

Compared with the dividend discount model for common shares, three things change:

• The dividend is a fixed preferred dividend D every period.
• A preferred share with a maturity date repays its face or par value FV at maturity instead of a terminal value.
• Priority over common shares shows up as a lower discount rate, the required return on preferred stock r_p , and r_p below r_e .

With no growth and no terminal value, there is no growth rate to estimate: this is the point of no terminal value for preferred .

Dividend discount model

• Common shares Know the idea growing dividends, r_e, a terminal value
• Preferred shares Memorize fixed D, r_p < r_e, FV at maturity or a perpetuity; no growth, no terminal value

How do you value a dated or a perpetual preferred share?

A preferred stock with a maturity date is valued like a bond: the present value of the dividends plus the present value of par.

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

A perpetual preferred stock has no maturity, so the dividends form a perpetuity.

$$IV_t = \frac{D}{r_p}, \quad D = \text{dividend rate} \times \text{par}$$

What return does a preferred share’s price imply?

Put the market price in place of the value and solve for the discount rate. For a perpetual share, this gives the implied required return on preferred .

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

Why is $r_p$ below $r_e$? Because preferred holders are paid before common holders, both dividends and assets in a liquidation. The size or type of the dividend does not set the discount rate.

How do call, put and conversion features change value?

Contingency features are rights, but not obligations, to redeem the shares at a set price or to convert them into common shares. The right has value to whoever holds it, so the share’s price (or dividend) differs from an otherwise identical plain share. Features that benefit the issuer lower the value to investors; features that benefit investors raise it.

• Callable preferred stock : the issuer can redeem the shares before maturity, often at par or at a premium that shrinks to par as maturity nears. The issuer calls when it suits the issuer (for example when it can refinance more cheaply), so the call lowers the share’s value at the same dividend rate, and issuers must offer a higher dividend to sell callable shares.
• Putable preferred stock : the investor can sell the shares back to the issuer at par or a set price. The investor holds the right, so putable shares carry a lower dividend than similar non-putable ones.
• Convertible preferred stock : the holder can exchange each preferred share for a fixed number of common shares, the conversion ratio , after a set period. It pays a dividend and ranks ahead of common shares like debt, and offers the upside of common equity; the conversion right is worth something to the holder, so the dividend is lower. Early-stage investors often take convertible preferred shares for that mix.

Valuing the conversion right comes later in the curriculum; there are no numbers for it here.

Ranking the expected dividend rate of otherwise identical shares, highest to lowest: callable > non-callable, non-convertible > putable; a convertible share also pays less than the plain one.

Non-callable, non-convertible preferredthe base case: D ÷ r_p, or bond-style with FV

• Callable by the issuer Memorize issuer's right: higher dividend, lower value at the same dividend
• Putable by the investor Memorize investor's right: lower dividend, higher value
• Convertible into common Memorize investor's right: lower dividend; conversion ratio

Exam tip Whoever holds the option pays for it. The issuer pays a higher dividend for a call; investors accept a lower one for a put or a conversion right.