Chapter 6 - Stock Valuation

Chapter 6 - Stock Valuation

Security Valuation In general, the intrinsic value ofan asset = the present value of the stream of expected cash flows discounted at an appropriate required rate of return.

Preferred StockA hybrid security: It’s like common stock - no fixed maturity.

Preferred StockA hybrid security: It’s like common stock - no fixed maturity. Technically, it’s part of equity capital.

Preferred StockA hybrid security: It’s like common stock - no fixed maturity. Technically, it’s part of equity capital.

It’s like debt - preferred dividends arefixed.

Preferred StockA hybrid security: It’s like common stock - no fixed maturity. Technically, it’s part of equity capital.

It’s like debt - preferred dividends arefixed. Missing a preferred dividend does not constitute default, but preferred dividends are cumulative.

Preferred Stock Usually sold for $25, $50, or $100 pershare. Dividends are fixed either as a dollar amount or as a percentage of par value. Example: In 1988, Xerox issued $75 million of 8.25% preferred stock at $50 per share. $4.125 is the fixed, annual dividend per share.

Preferred Stock Features Firms may have multiple classes ofpreferreds, each with different features. Priority: lower than debt, higher than common stock. Cumulative feature: all past unpaid preferred stock dividends must be paid before any common stock dividends are declared.

Preferred Stock Features Protective provisions are common. Convertibility: many preferreds areconvertible into common shares. Adjustable rate preferreds have dividends tied to interest rates. Participation: some (very few) preferreds have dividends tied to the firm’s earnings.

Preferred Stock Features PIK Preferred: Pay-in-kind preferredstocks pay additional preferred shares to investors rather than cash dividends. Retirement: Most preferreds are callable, and many include a sinking fund provision to set cash aside for the purpose of retiring preferred shares.

Preferred Stock Valuation A preferred stock can usually bevalued like a perpetuity:

Preferred Stock Valuation A preferred stock can usually bevalued like a perpetuity:

Vps =

D k ps

Example: Xerox preferred pays an 8.25%dividend on a $50 par value. Suppose our required rate of return on Xerox preferred is 9.5%.

Example: Xerox preferred pays an 8.25%dividend on a $50 par value. Suppose our required rate of return on Xerox preferred is 9.5%.

Vps =

4.125 .095

=

Example: Xerox preferred pays an 8.25%dividend on a $50 par value. Suppose our required rate of return on Xerox preferred is 9.5%.

Vps =

4.125 .095

=

$43.42

Expected Rate of Return on Preferred

Just adjust the valuation model:

Expected Rate of Return on Preferred

Just adjust the valuation model:

kps =

D Po

Example If we know the preferred stock price is$40, and

the preferred dividend is $4.125, the expected return is:

Example If we know the preferred stock price is$40, and the preferred dividend is $4.125, the expected return is:

kps

D = Po

4.125 = = 40

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