How to Calculate Preferred Stock: Key Formulas

Preferred stock is an equity investment with specific benefits not found in common stock. It provides ownership in a company while prioritizing dividend payments and claims on assets during liquidation. This makes preferred stock a hybrid instrument, sharing characteristics with both equity and debt. Understanding its calculations is important for investors and financial analysts to assess its value and impact.

Understanding Preferred Stock Fundamentals for Calculation

Preferred stock has distinct features. Its par value, also known as face value, is a nominal amount assigned to the stock at issuance. It serves as the basis for determining the fixed dividend amount. For example, if a preferred stock has a par value of $100, its dividends are calculated as a percentage of this $100, regardless of market price fluctuations.

The fixed dividend rate is typically expressed as a percentage of the par value. To calculate the annual dividend, this rate is multiplied by the par value. For example, a preferred stock with a $100 par value and a 5% dividend rate pays an annual dividend of $5 ($100 x 0.05). These dividends are generally paid at regular intervals, such as quarterly.

Preferred stock can be classified as either cumulative or non-cumulative. Cumulative preferred stock requires that any skipped dividends from past periods must be paid to preferred shareholders before any dividends can be distributed to common shareholders. In contrast, non-cumulative preferred stock does not accrue missed dividends. Preferred stockholders also have priority over common stockholders in receiving dividends and in claims on company assets during liquidation.

Calculating Preferred Stock Valuation

Preferred stock is often valued as a perpetuity, treating the fixed dividend stream as an infinite series of cash flows. The valuation formula for preferred stock as a perpetuity is: Preferred Stock Value = Annual Dividend / Required Rate of Return.

In this formula, the “Annual Dividend” refers to the fixed dollar amount paid to preferred shareholders. The “Required Rate of Return” represents the investor’s minimum acceptable return or market yield for similar investments. This rate reflects the opportunity cost of investing in the preferred stock.

For example, if a preferred stock pays an annual dividend of $6 and an investor requires a 7.5% rate of return, the valuation is: Preferred Stock Value = $6 / 0.075 = $80. The intrinsic value of this preferred stock is $80 per share.

Calculating Preferred Stock’s Impact on Earnings Per Share

Preferred stock dividends influence the calculation of Earnings Per Share (EPS) for common shareholders. EPS is a key profitability metric indicating how much profit a company generates for each outstanding common share. Preferred shareholders have a senior claim on a company’s earnings, meaning their dividends must be paid before any earnings are available to common shareholders.

To calculate EPS, preferred stock dividends must be subtracted from the company’s net income. This adjustment yields the “Net Income Available to Common Shareholders.” The formula for EPS is: EPS = (Net Income – Preferred Dividends) / Number of Common Shares Outstanding.

For instance, if a company reports a net income of $5,000,000, has $500,000 in preferred dividends, and 1,000,000 common shares outstanding, the calculation is: EPS = ($5,000,000 – $500,000) / 1,000,000 = $4.50. This indicates $4.50 of profit is attributable to each common share. Subtracting preferred dividends ensures EPS reflects earnings available to common stockholders, showing their proportional claim on profits.

Calculating Convertible Preferred Stock Value

Convertible preferred stock offers investors the option to exchange their preferred shares for a predetermined number of common shares. This conversion feature introduces an additional valuation consideration beyond the straight preferred stock value. A crucial component for calculating this conversion option’s value is the conversion ratio.

The conversion ratio specifies the fixed number of common shares that each preferred share can be converted into. This ratio is established at the time the convertible security is issued. To determine the conversion value, the formula is: Conversion Value = Conversion Ratio x Current Market Price of Common Stock.

For example, if a convertible preferred stock has a conversion ratio of 20 (meaning one preferred share can be converted into 20 common shares) and the current market price of the common stock is $35 per share, the conversion value is: Conversion Value = 20 x $35 = $700. Investors use this conversion value to assess whether converting their preferred shares into common shares would be financially advantageous, often comparing it to the preferred stock’s current market price.