October 2006

Valuation Issues with Respect to Preferred Stock

The value of a preferred stock lacking any common equity kicker, such as convertibility or other special features,
is equal to the present value of its future income stream discounted at its required yield of rate of return

There are two basic types of equity ownership in a corporation: common stock and preferred stock. While there is a seemingly endless amount of information that addresses the valuation of common equity, guidance on the valuation of preferred equity is less abundant. This article provides a brief background on the nature of preferred stock, its typical features, and how these features may impact the value of a particular preferred stock issuance.

The main characteristic of preferred stock is that the holder is contractually promised to be paid a fixed dividend every period until its expiration. This dividend is typically required to be paid before any dividend can be paid to the common stockholders, hence the term “preferred.”

In addition to the stated dividend, preferred stock can have many other characteristics that distinguish it from the common stock. For example, preferred stock usually has a preference over common stock in the event that the corporation liquidates (“liquidation” in the context of preferred stock refers to the sale of the business or its assets, as well as the completion of an initial public offering of the company’s common stock).

Preferred stock falls between debt and common stock in legal priority, privilege, and risk of ownership. While the investor in preferred stock may be surrendering some of the “upside” potential that common shareholders have, the preferred stockholder will expect to be protected from some of the “downside” potential by demanding special characteristics and contingencies.

Special Characteristics

The special characteristics of the preferred stock that are typically encountered are addressed below.

Dividend rate. The most common form of dividend is one that is fixed at an amount usually stated as a percentage of the preferred stock’s par value. The value attributable to the stated dividend rate of the preferred stock depends on the issuing company’s current and expected ability to pay the stated dividend rate and the current market yields of preferred stocks with similar dividend payment risk. A somewhat less common form of dividend is an adjustable-rate dividend, which typically is adjustable within a stated range and pegged to the general level of interest rates.

Liquidation preference. Another important characteristic of a preferred stock is its liquidation preference and the subject company’s ability to pay it in full at liquidation. In almost all cases, preferred stock carries a contractual right to preference (advantage) in the distribution of the issuing corporation’s assets upon liquidation. The preferred stock’s liquidation preference usually is stated as a certain dollar amount per share. Revenue Ruling 83-120 requires that the issuing corporation’s ability to pay the full liquidation preference at liquidation be taken into account in estimating the preferred stock’s fair market value.

Cumulative versus noncumulative dividends. The term cumulative, when applied to preferred stock dividends, means that if the dividends are not paid for one or more periods, the corporation has a contractual obligation to make up the lapsed payments before declaring and paying any dividends on the common stock or on other junior issues. Furthermore, many cumulative issues also give preferred stockholders voting rights and/or the right to elect one or more members to the board of directors following the nonpayment of one or more dividends. Cumulative dividends imply that the risk of nonpayment of dividends becomes secondary, because the cumulative feature requires that the shareholder not suffer a loss in income in the long run unless the company is never able to pay.

In addition, when dividends are cumulative, liquidation coverage tends to become more important than dividend coverage, because in the event of liquidation, cumulative dividends in arrears must be paid in addition to the stated liquidation preference before making any assets available for distribution to common shareholders.

In general, all other things being equal, the value of a noncumulative preferred stock would be significantly less than an otherwise comparable cumulative preferred stock, because dividends not paid on a noncumulative issue are lost permanently. Revenue Ruling 83-120 also addresses the cumulative versus noncumulative feature.

Redeemable versus nonredeemable. In many instances, a preferred stock has a contractual redemption provision. The type of redemption provision can vary significantly. The most common forms of redemption provisions are as follow:

• The entire issue is redeemable at the option of the issuing corporation at a specified price (typically par value) over a designated time period. These types of issues are commonly referred to as callable.

• The entire issue is redeemable at the option of the issuing corporation at a specified price contingent upon a certain event, such as the death of a major shareholder, a change in ownership control, or issuance of other securities.

• Future redemption by the issuing company is mandatory and based on a specific redemption schedule. These types of issues have sinking-fund provisions similar to the vehicle by which bonds are retired at intervals up to their maturity dates, and are referred to as sinking fund preferreds.

• The impact on value of the redemption privilege varies depending on the specific redemption provisions. Therefore, it is extremely important that the analyst be aware of all the contractual provisions and contingencies of the redemption.

Put options. A common characteristic of closely held preferred stock is a put option on the preferred shareholder’s behalf. This option allows the shareholder to require the issuing corporation to buy back the stock at some fixed price, usually par value. When a preferred stock can be put back to the company at par value, its value usually is, at a minimum, its par value, assuming the company has the financial ability to honor the put.

Voting versus nonvoting rights. In general, voting rights increase the value of preferred stock. Numerous studies of publicly traded preferred stocks have been conducted in an attempt to isolate the reduction in yield (and thus increase in value) investors accord to voting preferred stock.

Participating versus nonparticipating rights. A participating preferred stock gives the preferred stockholder the right to share in additional earnings beyond the amount or stated dividend rate described in the preferred stock contract. On the other hand, a nonparticipating preferred stockholder can receive dividends only in the amount specified in the contract. A fully participating preferred stock allows the stockholder to share with the common stockholder in any earnings disbursements after the common stockholders have received a certain specified annual payment. The incremental amount to the preferred shareholders in such a case normally is equal to that paid to the common stockholders. The value of the participating feature in a preferred stock is derived from the stockholder’s right to potentially higher dividends and depends on the likelihood that these potentially higher dividends will in fact be paid.

Convertible versus nonconvertible rights. Convertible preferred stock is similar to a convertible bond in that it is a combination of a preferred stock issue and an option on a common equity issue. The conversion feature gives the preferred stock a speculative quality – derived through future dividend payments – in addition to its investment value as a fixed-income security. Because of the speculative quality that the equity conversion feature imparts to the preferred stock, the stock’s value depends not only on its conversion rights and expected future income stream but on the value of the common stock as well.

Valuation Overview

Simply stated, the value of a preferred stock lacking any common equity kicker, such as convertibility or other special features, is equal to the present value of its future income stream discounted at its required yield of rate of return. The higher the risk inherent in the investment, the higher the required yield.

The difficulties encountered in valuing preferred stock result primarily from estimating the required yield rate given the stock’s myriad characteristics. Because of the flexibility in characteristics, the ability to estimate the value of preferred stock often depends more on the analyst’s experience and subjective judgment than on observable market evidence. ■