Understand Finance - Finance Tutorials and Finance How To's

Finding the value of a share of preferred stock could not be easier! Preferred stock
is unlike common stock in that the dividends paid to shareholders do not grow. The other
important factor to consider is that shares of preferred stock typically do not have a
maturity date. So putting these facts together, we have some payment (the dividend) that
occurs forever. Sound familiar? This is just like what we learned in our time value of
money section when we studied perpetuities.

There is a very simple formula to value preferred stock. Let’s take a look at it and
understand the notation:

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Now that we understand the basic formula for preferred stock valuation, lets try a
sample problem. UnderstandFinance preferred stock pays a $3 annual dividend and investors
require 9% for a stock of this risk level. What is the intrinsic value of this preferred
stock?

This one gives us all of the puzzle pieces up front! We have $3 as our value for D and
9% as our required rate. The only trick here is to remember to put the 9% in as a
decimal. Your formula should look like this:

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Before moving on to a slightly harder problem, we need to have a discussion on par
value of preferred stock. The par value is typically $25, $50, $75, or $100. This is
extremely important! Some problems will not give you a dollar value for a dividend, but
instead tell you the dividend rate. The dividend rate is simply the percent of
par value that is paid out each year in the form of dividends. The following problem will
show you what we’re talking about here:

Magic Carpet Company’s preferred stock has a par value of $50 and a dividend rate of
8%. If investors’ required rate is 10%, what is a fair price for this preferred
stock?

Here we need to turn that dividend rate into a dollar value. Just multiply the par
value times the dividend rate to get D. Your formula should look like this:

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Practice Problem 1
Wooden Pencil Accounting’s preferred stock recently paid a dividend of $5.50. The par
value of their preferred stock is $75. Investors require an 11.5% rate of return on this
stock. What is the intrinsic value of the preferred stock?

Solution:
You should have found an intrinsic value of $47.83. In this case, we
didn’t even need to know the par value since the dividend was given to us in dollars.

Practice Problem 2
FinanceCorp’s preferred stock has a par value of $50 and a dividend rate of 5%. Investors
require an 7% rate of return on this stock. What is the intrinsic value of the preferred
stock?

Solution:
Did you get an answer of $35.71? If not, make sure you are using decimal
form for your required rate!