The valuation of a simple preferred stock is one of the easiest things to learn, which is why new investors often learn about it early in their careers. But before getting too deep into the math, make sure you have a clear sense of what is meant by a stock's value because there are many ways to assess it.
Intrinsic value is the focus here, and unlike other methods, it does not look at the larger market, or current trading prices, or past patterns; nor does it attempt to predict future prices. Instead, it bases a stock's value on what an investor will pay for it. Simply put, intrinsic value is what a stock is worth to the buyer.
The simple formula is one that you'll have no trouble applying to your investment options. The best way to teach it to you is to walk through a mock version so you can see how the math works, and how it might work for you.
- The intrinsic value of a stock is what an investor is willing to pay for it without considering markets, current trading prices, or patterns.
- There are two main types of stocks, common and preferred, with preferred stocks receiving dividends first.
- Intrinsic value calculations for preferred stock are based on your annual dividend, the growth rate, and your required rate of return.
- Your growth rate cannot exceed your required rate of return or the equation won’t work.
Preferred Stock vs. Common Stock
If you're new to investing, you might not be aware that not all stocks are in the same form. The two main types of stocks are common stock and preferred stock. The biggest difference between the two has to do with the rights and perks they bestow upon their owners. When you buy shares of stock, you are also buying a small piece of ownership in a company, and the type of stock you buy will dictate your role, mostly with regard to voting rights and dividend payments.
Although the differences between common stock and preferred stock are mostly the same across the board, each company has the power to define the specific rights and perks for the classes of stock they issue.
When it comes time to vote for new board members of a company, for instance, shareholders with common stock will likely be the ones weighing in. Most often, each share of common stock comes with a voting right. The more shares you own, the more power you'll have in company-wide votes. Preferred stock does not usually come with voting rights, so no matter how many shares you own, you won't have a say in how the business is run.
While preferred stock doesn't entitle a holder to voting rights, it is of a higher class for a reason: preferred stock takes preference over common stock when it comes to payouts. The basic tenet of preferred stock is that it will receive dividend payments before common stock. If the company declares bankruptcy and has to liquidate all of its assets, holders of preferred stock will receive payouts before holders of common stock see a dime.
There is one higher class of security than preferred stock in this instance: if the company issues bonds, bondholders will receive assets before any type of stockholders do. (And of course, any debt that a company owes must be paid off before that.)
Within the two basic classes of common and preferred stock, there can be are other subclasses if the company structures it that way. Convertible stock, for example, might come with the option to convert preferred stock to common stock, such as to sell for a higher price.
How Preferred Stock Works
Let's walk through an example to explain how you can make a steady income when you invest in preferred stock. Suppose that you buy 1,000 shares of preferred stock at $100 per share for a total investment of $100,000. Each share of preferred stock pays a $5 dividend, resulting in a 5% dividend yield (you get this percentage by dividing the $5 dividend by the $100 stock price).
That means that you collect $5,000 in dividend income on your $100,000 investment every year. For this example, assume that this is a simple form of preferred stock and not one of the subtypes.
Since the example involves a simple form of preferred stock, you own what is known as a "perpetuity," which is a stream of equal payments paid at regular intervals without an end date. There is a simple formula for valuing perpetuities and basic growth stocks called the Gordon Growth Model, or the Gordon dividend discount model.
The formula is "k ÷ (i - g) = v." In this equation:
- "k" is equal to the dividend you receive on your investment
- "i" is the rate of return you require on your investment (also called the discount rate)
- "g" is the average annual growth rate of the dividend
- "v" is the value of the stock that will deliver your desired return
You can adjust the rate of return to fit your investing goals. There are many ways to come up with this figure, but the gist is that it sets a threshold for the least amount of return you'll settle for so that the investment is worth the expense.
Here are some intrinsic value calculations for simple preferred stock.
If the preferred stock has an annual dividend of $5 with a 0% growth rate (meaning that the company never increases or decreases the dividend), and you require a rate of return of 10%, the calculation would look like this:
- $5 ÷ (0.10 - 0)
- Simplified, this becomes $5 ÷ 0.10 = $50.
- In this scenario, if you wanted to earn a 10% rate of return, you couldn't pay more than $50 for the preferred stock. On the other hand, buying the stock at a price lower than $50 will result in a higher return.
Now let's say that preferred stock had an average dividend growth rate of 3% per year, and you require a rate of return of 7%. You would calculate:
- $5 ÷ (0.07 - 0.03)
- Simplified, this becomes $5 ÷ 0.04 = $125
- In this scenario, if you wanted to earn 7% on your preferred stock investment, and you expect the dividend to increase by 3% annually, you could pay $125 per share and still hit your return goals. If you pay more than that, your return will be lower than 7%. If you pay less, your return will be higher than 7%.
A Limitation to the Intrinsic Value Calculation
One limitation of the intrinsic value formula is that you cannot have a growth rate that exceeds your desired rate of return. If you do, your calculator will return an error or indicate infinity. That's because perpetuity is expected to last forever—from now until the end of time—and the math will back it up.
If the rate of growth exceeds the required rate of return, the value of the investment is, in theory, infinite. No matter what price you pay for the preferred stock, you are someday going to hit your rate of return and exceed it. What the equation doesn't account for is the human lifespan, and whether the timeline for reaching the required rate of return is feasible.
Other than that one small quirk, this equation is all you need to calculate the intrinsic value of a simple preferred stock.