What is Foolsaurus?

It's a glossary of investing terms edited and maintained by our analysts, writers and YOU, our Foolish community. Get Started Now!


What Is the Formula to Figure the Cost of Preferred Stock?

Original post by Wilhelm Schnotz of Demand Media

The value of common stock -- the type of corporate stock traded on the markets -- is determined by a variety of factors, such as its operational expenses and profit rates. Preferred stock holders receive a constant dividend, which is paid prior to determining profits to declare common-stock dividends. Because of its constant dividends, calculating preferred stock's price is relatively simple, and is based on its required rate of return.

Contents

Preferred Stock Valuation Formula

While preferred stockholders hold a share of a company's equity, the value of preferred stock is directly related to the dividend it pays, and investors' expected return on their investment. Rather than valuing preferred stock as common stock, think of preferred stock along the lines of an annuity that never matures: Holders of preferred stock receive dividends in perpetuity. To determine the value of any preferred stock, simply divide its annual dividend by the rate of return you require. Mathematically, that's expressed as P = D/R. Where P represents price, D represents dividends per share and R signifies the desired rate of return.

Expected Return Formula

Because its dividends remain stable, preferred stock's expected rate of return can also be easily calculated when you know the price per share and dividend information. The expected rate of return on any investment into preferred stock may be calculated by dividing its dividend by its price. This can be expressed as R = D/P. With variables representing rate, dividend and price figures in the same manner as the valuation formula.

Determining Purchase Price

As with any valuation tool, the price of preferred stock is ultimately determined by investors. The price you pay for a share of preferred stock depends upon how aggressively you want the investment to perform as well as the performance of similar investments in other sectors of the market. Knowing the dividend paid each year, an investor may utilize the valuation formula to determine a price that will meet his requirements.

Valuation Example

To illustrate how a valuation is determined, assume a company's preferred stock pays $1.76 per share. An investor who requires a return of 8 percent would be willing to pay $22 per share, or $1.76/0.08, to meet the required return on his investment. A less aggressive investor may view the stock as a safe investment, and require a 6.5 percent rate of return on the investment. The second investor would be willing to pay $27.08 per share to achieve that rate of return.


                   

References

About the Author

Wilhelm Schnotz has worked as a freelance writer since 1998, covering arts and entertainment, culture and financial stories for a variety of consumer publications. His work has appeared in dozens of print titles, including "TV Guide" and "The Dallas Observer." Schnotz holds a Bachelor of Arts in journalism from Colorado State University.


Advertisement