Saturday, March 21, 2009

Preferred Stock: Fish or Fowl?

In my last post, I talked about hybrids but I stuck with the conventional example of convertible debt. In this one, I would like to draw attention to another source of financing - preferred stock - which I find much more difficult to work with.

Before I begin, though, let me also draw a distinction between preferred stock in the United States and preferred stock in some other parts of the world (such as Brazil). In the United States, preferred stock commands a fixed dollar dividend that is set at the time of the issuance. If you buy preferred stock, your returns come primarily from the dividends - any price appreciation (or depreciation) is a side story. In much of Latin America, preferred stock is really common stock with preferential claims on dividends and limited voting rights. The dividends are usually specified as a percentage of earnings (rather than as an absolute number) and will go up, if the company is doing well, and go down, if not. Returns therefore mirror returns on common stock, with dividends and price appreciation.

Where should we put preferred stock in the cost of capital computation?
1. With the "common stock" variety preferred, the answer is easy. Treat it as equity, even though it may be called preferred stock.
2. With the "fixed dividend" preferred stock, our task becomes more difficult. It is clearly not equity, notwithstanding what it is called, since your claim is on a fixed dividend. (If you have preferred stock that is entitled to more cash flows, such as a share of the remaining profits, I would consider it equity). Including this item in debt creates a problem, since preferred dividends are not tax deductible (and attaching an after-tax cost of debt to the overall debt will understate the cost of preferred).

Here is my compromise solution. If the value of preferred stock is less than 5% of overall firm value (market), act like it does not exist for cost of capital purposes and subtract the preferred dividend out from earnings and cash flows. (It will make little difference to your cost of capital, if you do include it, and more headaches than it is worth) If it is more than 5%, we have no choice but to create a third source of capital and give it it's own cost. The cost of preferred stock should be the preferred dividend yield (which will be lower than the cost of equity but higher than the pre-tax cost of debt).
Preferred dividend yield = Preferred dividend per share/ Preferred stock price

The puzzle then becomes the following. Preferred stock is essentially very expensive debt (because you do not get the tax advantage). So, why would any sensible firm even use it to raise capital? More on that in my next post.


Bojan Kunovar said...

Another issue: how do you calculate the cost of capital for preferred stock if it is not quoted and you have no data to calculate the dividend yield?
Should it in general be somewhere between the (pre-tax) cost of debt and cost of equity. And then you determine to which it is closed based on some other characteristics (such as potential voting rights etc.).


Aswath Damodaran said...

What data do you need to compute the dividend yield? The dividends (which should be known) and the price of the preferred stock... The question of which one it will be closer to partly determined by voting privileges and more often by the nature of the claim (fixed or residual)

Bojan Kunovar said...

If the stock is not quoted, you don't know the price. So you only know the dividend, but not the price or the yield. How do you then value this stock?


Aswath Damodaran said...

If the preferred stock is not quoted, you have two choices. One is to estimate a preferred dividend rate by looking at what preferred stock of similar risk is fetching at other companies or use the book value of preferred stock.

Mohammed AIT LAHCEN said...

I think that the very nature of prefered stock is, as you said, different depending on the financial and legal system of the country. For the french system (which is in use also in french speaking african countries), the dividend yield of prefered stocks is fixed each year by the AGM and it is given the priority over common stocks. In practice, there is two levels of dividends, the prefered one which is given only to prefered stocks and the common one which is given to all shareholders. I don't know if this may have any incidence on the valuation process.

Unknown said...

What if the preferred stock is non-cumulative and non-convertible? The dividend may be fixed but may not accrue every year depending on the cash flow generation capacity of the company.

What if the preferred stock is non-cumulative and and convertible? Do we need to forecast and make assumptions as to when a company would be paying preferred dividend and when it would get converted in to common stock? How the cost of capital would ideally be computed for such complex hybrid structures?

Term Papers said...

You don't know the price. So you only know the dividend, What if the preferred stock is non-cumulative and and convertible? I really didn't know about it.


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