How do you value preferred stock using the perpetuity model, and what drives preferred stock yields?
I'm studying equity valuation for CFA Level I and I'm confused about preferred stock. My textbook says it can be valued as a perpetuity, but what about callable preferred stock or preferred with adjustable rates? What makes preferred stock trade at a premium or discount to par?
Preferred stock is a hybrid security — it has features of both equity and fixed income. For CFA Level I, the perpetuity model is the primary valuation approach.
The Perpetuity Model:
Since preferred stock pays a fixed dividend indefinitely (no maturity date):
V_preferred = D_preferred / r
Where D_preferred is the annual preferred dividend and r is the required rate of return.
Example:
Sterling Industries issues preferred stock with a $100 par value paying a 6% annual dividend. Investors require an 8% return.
V = $6.00 / 0.08 = $75.00
The preferred stock trades at a discount ($75 < $100 par) because the coupon rate (6%) is below the market's required return (8%).
What Drives Preferred Stock Prices?
| Factor | Impact on Price | Explanation |
|---|---|---|
| Market interest rates rise | Price falls | Higher discount rate |
| Credit quality deteriorates | Price falls | Higher required return |
| Rates fall below coupon | Price rises (but may be called) | Lower discount rate |
| Call feature | Limits upside | Issuer redeems at par when rates fall |
Callable Preferred Stock:
If Sterling's preferred is callable at $102, and market rates drop to 4%:
- Theoretical value: $6 / 0.04 = $150
- But Sterling will call it at $102
- Market price will approach $102, not $150
Callable preferred stock has a price ceiling near the call price, which creates negative convexity — a concept you'll explore more deeply in CFA Level II fixed income.
Adjustable-Rate Preferred Stock (ARPS):
The dividend rate resets periodically (e.g., quarterly) based on a benchmark rate. Because the dividend adjusts to market conditions, ARPS trades closer to par value and has lower price volatility than fixed-rate preferred.
Preferred vs. Common Stock:
- Preferred dividends are fixed and take priority over common dividends
- Preferred holders generally have no voting rights
- In liquidation, preferred claims come before common but after all debt
- Preferred dividends may be cumulative (missed dividends accumulate) or non-cumulative
Exam tip: The CFA Level I exam frequently presents a preferred stock with a par value, stated dividend rate, and required return, then asks for the intrinsic value. Remember: this is simply D/r. Watch for questions that test whether the preferred trades at a premium (coupon rate > required return) or discount (coupon rate < required return).
For more equity valuation practice, check our CFA Level I question bank on AcadiFi.
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