Foundations of Financial Management: An Analysis (part 35)

“Money can’t buy happiness, but it will certainly get you a better class of memories.”

- Ronald Reagan

Valuation and Rates of Return (part E)

by

Charles Lamson

Valuation and Preferred Stock

Preferred stock usually represents a perpetuity or, in other words, has no maturity date. It is valued in the market without any principal payment since it has no ending life. If preferred stock had a maturity date, the analysis would be similar to that of the preceding bond example presented in the previous posts. Preferred stock has a fixed dividend payment carrying a higher order of precedence than common stock dividends, but not the binding contractual obligation of interest on debt. Preferred stock, being a hybrid security, has neither the ownership privilege of common stock nor the legally enforceable provisions of debt. To value a perpetuity such as preferred stock, we first consider the formula: 

It is not surprising that preferred stock is now trading well above its original price of $100. It is still offering a $10 dividend (10 percent of the original offering price of $100), and the market is demanding only an 8 percent yield. To match the $10 dividend with the 8 percent rate of return, the market price will advance to $125.

Determining the Required Rate of Return (Yield) from the Market Price

MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 279-281*

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