Presentation on theme: "Semih Yildirim ADMS 3530 6-1 Chapter 6, 13.1 &13.2 Valuing Stocks Chapter Outline Stocks and the Stock Market Book Values, Liquidation Values, and."— Presentation transcript:
Semih Yildirim ADMS Chapter 6, 13.1 &13.2 Valuing Stocks Chapter Outline Stocks and the Stock Market Book Values, Liquidation Values, and Market Values Valuing Common Stocks Simplifying the Dividend Discount Model Growth Stocks and Income Stocks Market Efficiency Corporate Financing: Common Stocks and Preferred Stocks
Semih Yildirim ADMS Stocks and the Stock Market Definitions Primary Market: Place where the sale of new stock first occurs. Initial Public Offering (IPO): First offering of stock to the general public. Seasoned Issue: Sale of new shares by a firm that has already been through an IPO. Secondary Market: Market in which already issued securities are traded by investors.
Semih Yildirim ADMS Stocks and the Stock Market Definitions Corporations can also raise long term money by issuing and selling securities which are called stocks or shares. Investors who purchase these shares are called stockholders or shareholders. Issuing stock is like taking on new partners. Shareholders become part-owners of the issuing firm, electing a board of directors to represent their interests. The shareholders are entitled to the firm’s residual cash flow. The residual cash flow is the remaining cash flow after all employees, suppliers, lenders and the government have been paid. The stockholders, as owners, share in the fortunes of the firm. Shares of stock can be risky investments!
Semih Yildirim ADMS Stocks and the Stock Market Dividends Dividends are periodic cash distributions from the firm to its shareholders. They represent that share of the firm’s profits which are distributed. Profits can also be retained in the firm and reinvested in its operations: Profits which are kept in the firm are called retained earnings. If you look at Table 6.2, you will see that different firms have different dividends: Some firms pay no dividends at all! Dividends, unlike coupon payments, are not fixed -- they represent a share in the profits and profits can go down … Though you hope that profits, and thus the dividend, will grow with time!
Semih Yildirim ADMS Stocks and the Stock Market Dividends The dividend yield is calculated the same way as the current yield on a bond – divide the annual income by the price of the security: For Canadian Tire, the dividend is $0.58 on a price of $ Dividend Yield =$0.58/$97.50=0.59% Note that investors will accept low, or zero, current yields if they can look forward to: Higher future dividends. Rising share prices. Note also, that like the current yield, the dividend yield calculation ignores potential capital gains or losses. Therefore, like the current yield, it is a poor measure of total return on your investment. Dividend Yield = Dividend Payment Stock Price
Semih Yildirim ADMS Stocks and the Stock Market Price-Earnings (P/E) Ratio The P/E ratio is the price of the stock divided by the earnings per share (eps). P/E Ratio = Stock Price EPS For the Canadian Tire the P/E multiple is reported as The P/E ratio measures how much an investor would pay for every $1 of eps: For Canadian Tire, investors are willing to pay $27.4 for each $1 of earnings the company generates. Key questions: Why does one stock sell for more than another? How do we value a stock?
Semih Yildirim ADMS Book Value, Liquidation Value, and Market Value There are three methods used for valuing a company’s shares: Book value: is the net worth of the firm according to its balance sheet and records all of the money the firm has raised from selling shares and from retained earnings. In Table 6.1, you can see a balance sheet dated January 1, 2005, for Canadian Tire: Molson has $5,218 million in assets. It has liabilities of $2,967.4 million. Book Value = $5,218 - $2,967.4 = $2,251.2 million Assume Molson has 81.1 million shares outstanding. That means the book value per share (bvps) for Molson is: $ million / 81.1 million = $27.75 per share On the same day, its market value per share was $56.21 Investors do not equate book value and market value because they know that book value is based on the historic cost of the assets. Historic cost is not a good guide to the value of those assets today.
Semih Yildirim ADMS Valuing a Stock Liquidation Value What if we were to liquidate all of the assets on Canadian Tire’s balance sheet and pay off the liabilities. Key Question: Would the remaining cash per share equal the market value for Molson shares? No! A successful company ought to be worth more than its liquidation value. The difference between liquidation value and market value may be attributed to what is known as going concern value. A well-managed company is worth more than simples sum of its assets
Semih Yildirim ADMS Valuing a Stock Going Concern Value Going concern value means that a well managed, profitable firm is worth more than the sum of the value of its assets. ASSET 1 $3 million ASSET 2 $2 million ASSET 3 $6 million Assets sold separately have liquidation value of $11 million ASSET 1 $3 million ASSET 2 $2 million ASSET 3 $6 million The same assets functioning as a firm have going concern value of $15 million
Semih Yildirim ADMS Valuing a Stock Sources of Going Concern Value Extra earning power. If Molson can use its physical assets more efficiently than a competitor could, then those assets are worth more than their resale value (book value). Intangible assets. Molson may have extremely valuable assets, such as brand names, which do not appear on the balance sheet, but are reflected in the market value. Value of future investments. If Molson shareholders believe that Molson has opportunities to invest in lucrative projects which will increase the company’s future earnings, they will pay more for the company’s shares today.
Semih Yildirim ADMS Valuing a Stock Market Value Book Value or Liquidation Value Stocks rarely sell at either book value or liquidation value. Unlike market value, book value and liquidation value do not treat the firm as a going concern. Market value is the amount investors are willing to pay today for the shares of the firm. This depends on the earning power of the existing assets and the expected profitability of future investments. HOW DO WE MEASURE MARKET VALUE?
Semih Yildirim ADMS Valuing Common Stocks Expected Return In Chapter 5, you learned how to calculate the expected return on a security: Assuming that: The current price of the shares is P 0. The expected price a year from now is P 1. The expected dividend a year from now is D 1. Expected Return = income + price change investment = D 1 + P 1 – P 0 P 0
Semih Yildirim ADMS Valuing Common Stocks Expected Return Note that expected return can be divided into two parts: Assume that for Blue Sky shares: The current price of the shares is $75. The expected price a year from now is $81. The expected dividend a year from now is $3. What is Blue Sky’s expected return? Expected Return = $ – 75 = 0.12 = 12% $75 Expected return = Dividend Yield + Capital Gain = D 1 + P 1 – P 0 P 0 P 0
Semih Yildirim ADMS Valuing Common Stocks Expected Return For Blue Sky: Expected return = Dividend Yield + Capital Gain = D 1 + P 1 – P 0 P 0 P 0 = $3 + $81 - $75 $75 $75 = = 4% + 8% = 12%
Semih Yildirim ADMS Valuing Common Stocks Expected Return vs Actual Return Expected return is a forecast of what the return would be if your predictions about the price and the dividend are correct. However, the actual return on a stock could be more or less than what you expect! Calculate how well you did as versus the 12% expected return if the following occurs to Blue Sky stock: The actual price a year from now is $61. The actual dividend a year from now is $3.
Semih Yildirim ADMS Common Stock Valuation Unlike bonds, valuing common stock is more difficult. Why? 1. The timing and amount of future cash flows is not known. 2. The life of the investment is essentially forever. 3. There is no way to observe the rate of return that the market requires.
Semih Yildirim ADMS Common Stock Valuation Remember: The value today of any financial asset equals the present value of all of its future cash flows. As with bonds, the price of the stock is then the present value of these expected cash flows One method to determine the price of a share of stock is to calculate present value of all future dividends. (Dividend Discount Model-DDM) P 0 = Σ [D t /(1 + r) t ] where t = 1 to ∞ How many future dividends are there? In principle, there can be an infinite number. For stocks we can make a simplifying assumption that the firm will pay dividends (cash flows) in perpetuity.
Semih Yildirim ADMS Common Stock Valuation To help us value a share of stock, we need to make some simplifying assumptions about the pattern of future dividends. The three cases we consider are: 1. The dividend has a zero growth rate. 2. The dividend grows at a constant rate. 3. The dividend grows at a constant rate after some length of time.
Semih Yildirim ADMS Zero Growth Stocks A share of common stock in a company with a constant dividend is much like a share of preferred stock. The firm will pay a constant dividend forever As such, D 1 = D 2 = D 3 = … = D t Since the dividend is always the same, the stock can be viewed as an ordinary perpetuity with a cash flow equal to D every period. Thus, t he price can be computed using the perpetuity formula P 0 = D 1 /r
Semih Yildirim ADMS Constant Growth Suppose we knew that the dividend for some company always grows at a steady rate (g). As long as the growth rate (g) is less than the discount rate (r), the present value of the series of cash flows can be written simply using the growing perpetuity formula: P 0 = Do x (1 + g) = D 1 r – g r – g where D 0 = the most recent dividend paid D 1 = the next dividend to be paid
Semih Yildirim ADMS Constant Growth We can actually use the dividend growth model to get the stock price at any point in time, not just today. In general, the price of the stock as of time t is: P t = D t x (1 + g) = D t+1 r – g r – g Note: The model only works when the discount rate is greater than the growth rate.
Semih Yildirim ADMS Constant Growth Example: ABC Corporation just paid a $2.50 per share dividend to its common shareholders. An investment in ABC is considered relatively risking and requires a discount rate of 20% per annum. It is forecasted that dividends in ABC are going grow at a rate of 6% per annum indefinitely into the future. How much will an ABC share be worth today? In 10 years? Step 1: Solve for D 0 and D 10 D 0 = $2.50 D 10 = 2.50 x (1 +.06) 10 = $4.48 Step 2: Solve for P 0 and P 10 P 0 = (2.50 x 1.06)/( ) = $18.93 P 10 = (4.48 x 1.06)/( ) = $33.92
Semih Yildirim ADMS Non-Constant Growth At times, a new company may pay no dividends early in its life but start paying dividends that grow at a constant rate some time in the future. At other times, a new company may pay small dividends initially and, at some point in the future, start paying dividends that grow at a constant rate. However, as always, the value of the stock is the present value of all future dividends. Many cash flow scenarios are possible in this situation.
Semih Yildirim ADMS Non-Constant Growth Example 1: ABC Compan’s dividend this year is $1.20 per share and dividends will grow at10% per year for the next 3 years, followed by 6% annual growth. The appropriate discount rate (required rate of return) for ABC stock is 12%. What is the value of a share of ABC common stock? D1= 1.32PV of D1 = D2= PV of D2 = D3= PV of D3 = D4= P 3 = D4 / (r-g) = /(.12 –.06) = $ P 0 = [ (1.12) -3 ] +( =$ = $
Semih Yildirim ADMS Example 2 Suppose a firm is expected to increase dividends by 20% in one year and by 15% in two years. After that dividends will increase at a rate of 5% per year indefinitely. If the last dividend was $1 and the required return is 20%, what is the price of the stock? Remember that we have to find the PV of all expected future dividends. Compute the dividends until growth levels off D 1 = 1(1.2) = $1.20 D 2 = 1.20(1.15) = $1.38 D 3 = 1.38(1.05) = $1.449 Find the expected future price P 2 = D 3 / (R – g) = / ( ) = 9.66 Find the present value of the expected future cash flows P 0 = 1.20 / (1.2) + ( ) / (1.2) 2 = Non-Constant Growth
Semih Yildirim ADMS Example Metallica Bearings, Inc. is a young start-up company. No dividends will be paid on the stock over the next 5 years. The company will pay a $6 per share dividend in six years and will increase the dividend by 5% per year thereafter. If the required return on this stock is 21%, what is the current share price? The current market price of any financial asset is the present value of its future cash flows, discounted at the appropriate required return. In this case, we know that: D 1 = D 2 = D 3 = D 4 = D 5 = 0 D 6 = $6.00 D 7 = $6.00(1.05) = $
Semih Yildirim ADMS Solution This share of stock represents a stream of cash flows with two important features: First, because they are expected to grow at a constant rate (once they begin), they are a growing perpetuity; Second, since the first cash flow is at time 6, the perpetuity is a deferred cash flow stream. Therefore, the answer requires two steps: 1.By the constant-growth model, D 7 /(r - g) = P 6 ; i.e., P 6 = $6.30/( ) = $ And, P 0 = (P 6 +D 6 )/(1.21) 6 =( )/(1.21) 6 = $
Semih Yildirim ADMS Valuing Common Stocks DDM vs Expected Rate of Return The DDM can be rearranged so that we can calculate the expected rate of return on the stock: r = D 1 P0P0 + g = Dividend Yield + Growth Rate What is the expected return for Blue Sky if: Next year’s dividend (D 1 ) will be $3. Dividends grow at 8% in perpetuity. The current price is $75.
Semih Yildirim ADMS Valuing Common Stocks DDM vs Expected Rate of Return The expected rate of return on Blue Sky would be: r= D 1 P0P0 + g = Dividend Yield + Growth Rate = $3 $ = =4%+8%=12%
Semih Yildirim ADMS Valuing Common Stocks Calculating “g” (growth rate) How fast a firm grows depends on how much of its profits are reinvested in operations: The fraction of earnings retained by the firm is called the plowback ratio. The fraction of earnings a company pays out in dividends is called the payout ratio. What is Blue Sky’s payout ratio and plowback ratio if: It has eps of $5. It pays a dividend of $3 and retains the balance.
Semih Yildirim ADMS Valuing Common Stocks Calculating “g” (growth rate) What is the payout ratio? The plowback ratio? Payout ratio= Dividend/ eps = $3/ $5 = 0.60 = 60% Plowback ratio = 1 – payout ratio = 1 – 0.60 = 0.40 = 40%
Semih Yildirim ADMS Valuing Common Stocks Calculating “g” (growth rate) Assume that Blue Sky can earn a 20% return on new equity investments. If all of its earnings were reinvested, Blue Sky would grow at 20% per year. If all of its earnings were paid out as dividends – i.e., none of the earnings were reinvested – then Blue Sky would forgo any growth (growth = 0%). If part of its earnings were reinvested, then Blue Sky would grow at between 0% and 20% per year. You should see that the higher the plowback rate, the higher the growth rate.
Semih Yildirim ADMS Valuing Common Stocks Calculating “g” (growth rate) You can calculate the growth rate for a company by multiplying the return on equity by the plowback ratio: g= roe x plowback ratio For Blue Sky, the growth rate would be: g= roe x plowback ratio = 20% x 40% = 8% Growth rates calculated this way are known as Sustainable Growth Rates
Semih Yildirim ADMS Valuing Common Stocks Growth Stocks vs Income Stocks Let’s try a few problems with Blue Sky and see what we can learn about growth and stock value. In all cases, assume that Blue Sky has: Expected eps of $5 next year. A discount rate of 12%.
Semih Yildirim ADMS Valuing Common Stocks Growth Stocks vs Income Stocks Problem 1: Assume that Blue Sky has: A payout ratio of 100%. What is the value of Blue Sky stock? Problem 2: Assume now that Blue Sky has: A payout ratio of 60%. The roe on new investment is 10%. What is the value of Blue Sky stock? Problem 3: Assume now that Blue Sky has: A payout ratio of 60%. The roe on new investment is 12%. What is the value of Blue Sky stock? Problem 4: Assume now that Blue Sky has: A payout ratio of 60%. The roe on new investment is 20%. What is the value of Blue Sky stock?
Semih Yildirim ADMS Valuing Common Stocks Growth Stocks vs Income Stocks Prob. # Plowback RatioROE g (Sustainable growth rate) Div 1 P0P0 10%*0.0%$5.00$ %10%4.0%$3.00$ %12%4.8%$3.00$ %20%8.0%$3.00$75.00 * Since the plowback ratio = 0%, sustainable growth rate will equal 0% regardless of the ROE. Thus, ROE is irrelevant. You should get the following results: *
Semih Yildirim ADMS Valuing Common Stocks In Problem 1 If Blue Sky does not reinvest any of its earnings, then its stock price would be $ o This price represents the value of earnings from assets which are already in place In Problem 2 If Blue Sky invests in projects which generate a return less than its discount rate, then its stock price would drop to $ o With zero growth, Blue Sky stock was worth $ o The share price is $4.17 lower because of investing in projects with an unattractive rate of return! Successful financial managers do not invest in projects which earn less than the discount rate – it would reduce the value of the company’s shares! In Problem 3 If Blue Sky invests in projects with a return equal to its discount rate, then its stock price would be $ o But, this is the same price as for zero growth …why didn’t growth translate into a higher share price? Plowing earnings back into a company does not add value unless investors believe the reinvested earnings will earn more than the discount rate. In Problem 4 If Blue Sky invests in projects with a return which is greater than its discount rate, then its stock price would rise to $75. o We know from Problem 1, that $41.67 is the value of the earnings from assets which are already in place. o Thus, $33.33 ($75 - $41.67) represents the value to investors of the superior return on future investments. This is know as the Present Value Of Growth Opportunities (PVGO)
Semih Yildirim ADMS Valuing Common Stocks Growth Stocks vs Income Stocks The earnings potential of Blue Sky will be reflected in its Price-Earnings ratio. Blue Sky has expected earnings of $5. With high growth prospects, its price is $75: Its P/E ratio = P/eps = $75 / $5 = 15x15.0 x With no growth prospects, its price is $41.67: Its P/E ratio = P/eps = $41.67 / $5 = 8.3X8.3 x Successful financial managers know that to justify a high P/E ratio on their company’s stock, they must deliver … … lots of growth opportunities!
Semih Yildirim ADMS What is an Efficient Market? Market Efficiency In efficient capital markets security prices rapidly reflect all relevant information about asset values. Thus, all securities are fairly priced in light of the information which is available to investors. If securities are fairly priced, then selling securities at prevailing market terms is never a positive NPV transaction. Likewise, when buying securities, it is impossible to consistently earn excess profits.
Semih Yildirim ADMS What is an Efficient Market? Random Walk Studies of the market have shown that market prices follow a random walk. A random walk means that security prices change randomly without predictable trends or patterns. That is, stock prices seem to wander randomly, just as likely to go up as down, on any particular day, regardless of what has occurred on previous days. Many studies of the market have shown that studying past price information provides little information about future price changes. Does the fact that stock prices follow a random walk mean that they are just “plucked out of a hat”? No, that is not the correct conclusion! What the Random Walk Theory means is this: If the stock of ABC jumps up today, you cannot assume that it will do the same thing tomorrow. However, ABC’s price change didn’t just pop out of nowhere! There must have been a good reason for the change in price … Did they report increased earnings? Or, a new product line which investors expect will boost profits? Or, …
Semih Yildirim ADMS What is an Efficient Market? Technical Analysis Technical analysts are investors who attempt to identify over- or undervalued stocks by searching for patterns in past prices. However, if stock prices follow a random walk then technical trading rules are useless. Technical analysis may not work, but technical analysts can help keep the markets efficient! Fundamental Analysis Fundamental analysts are investors who attempt to find over- and undervalued securities by analyzing fundamental information, such as earnings, asset values, and business prospects. Can fundamental analysts “beat the market” and deliver excess returns to investors? Researchers have looked at various types of fundamental information – earnings and dividend announcements, plans to issue securities or to merge, and other types of macroeconomic news. Their conclusions? Market prices already reflect all publicly available information. Thus it is impossible to make superior returns by studying such information.
Semih Yildirim ADMS Efficient Market Theory There are 3 forms of the efficient-market theory: 1. Weak form (the random walk theory) Market prices reflect all information contained in past market prices. You can’t make superior profits by studying past stock prices 2. Semi-strong form Market prices reflect all publicly available information. Many researchers have looked at various types of fundamental information such as earnings and dividend announcements, plans to issue securities or to merge, or other types of macroeconomic news And found that market prices already reflect all publicly available information. It is impossible to make superior returns by studying such information. 3. Strong form Market prices reflect all known information potentially available to determine true value. If markets are strong-form efficient, then it is impossible to beat the market’s performance by studying any kind of information. Your best solution as an investor would be to hold a diversified portfolio of securities such as an index
Semih Yildirim ADMS Corporate Financing The Types of Long-Term Finance Firms promise to repay their debt, plus interest. If they don’t keep that promise, the debtholders can force the firm into bankruptcy. No such commitments are made to the equity holders. They are entitled to whatever is left over after the debt holders have been paid off. For this reason, equity is called a residual claim on the firm.
Semih Yildirim ADMS Common Stock Equity Most major corporations are far too large to be owned by one investor. For example, you would need billions of dollars to purchase BCE. As a consequence, companies like BCE are owned by many investors, each of whom holds a number of shares of the firm’s common stock. These investors are known as shareholders or stockholders.
Semih Yildirim ADMS Common Stock Terminology Par Value The value of the security as shown on the share certificate. The par value was an arbitrary monetary value put on the shares before issue. It was almost always lower than the actual sales price of the new shares. Canadian companies no longer issue par value shares. Authorized Share Capital The maximum number of shares which a company is permitted to issue as specified in the firm’s articles of incorporation. Issued Shares The shares that have been issued by the company. Outstanding Shares Issued shares which are in the hands of investors. Additional Paid-In Capital The difference between the par value and the original selling price of the share. Also called paid-in surplus, capital surplus or contributed surplus. Retained Earnings Money plowed back into the company rather than being paid out as dividends.
Semih Yildirim ADMS Common Stock Treasury Shares Sometimes a company repurchases shares it issued in the past from its shareholders. In the US, these shares are recorded on the Balance Sheet as Treasury Shares. In Canada, repurchased shares must be cancelled, reducing the company’s net equity by the amount paid for the repurchased shares.
Semih Yildirim ADMS Common Stock Book Value vs Market Value You have already learned that book value is not the same as market value. Book value is a backward-looking measure. It tells you how much capital the firm raised from its shareholders in the past. Book value is not a measure of the value that investors place on those shares today. Market value is forward looking. It depends on the future dividends which shareholders expect to receive. Market value usually exceeds book value because: Inflation has driven the value of many assets up above their historic cost. Firms raise capital to invest in projects. If these projects have a positive NPV, then the value of the firm increases.
Semih Yildirim ADMS Common Stock Dividends Shareholders hope to receive dividends on their investment. However, there is no obligation on the firm to pay dividends. The decision to pay dividends is up to the Board of Directors. Because dividends are discretionary, they are not considered a business expense. Thus companies are not allowed to deduct dividend payments to calculate taxable income.
Semih Yildirim ADMS Common Stock Shareholder Rights Shareholders own the company and thus, ultimately, they have control of the company’s affairs. On most matters, shareholders have the right to vote on appointments to the Board of Directors. On a few matters, the shareholders have a direct say before a company may take action. For example, mergers need shareholder approval. The Board of Directors are supposed to manage the company in the interests of the shareholders. They are elected as the agents of the shareholders. They appoint and oversee the management of the firm.
Semih Yildirim ADMS Common Stock Voting Procedures Shareholders control the firm by the vote attached to their common shares. In most companies, the Directors are elected by a a majority voting system. Shareholders cast one vote for each share they own. Let’s say there are 5 candidates for the Board. If you owned 100 shares, you would cast in total 500 votes, but to a maximum of 100 votes for each candidate. Some companies operate a cumulative voting system. This is a system in which all the votes one shareholder is allowed to cast can be cast for one candidate. For example, you own 100 shares and there are 5 candidates. Thus you have in total 500 votes. You may cast up to all 500 votes for your favourite candidate.
Semih Yildirim ADMS Common Stock Voting Procedures A cumulative voting system makes it easier for a minority group of shareholders to elect a director to represent their interests. Thus minority shareholders tend to favour this type of systems as versus a majority voting system. Shareholders can vote in person or appoint someone else to represent their interests. This is known as appointing a proxy to vote. In proxy contests, outsiders compete with the firm’s existing managers and directors for control of the company. They do this by requesting the shareholders’ proxies.
Semih Yildirim ADMS Common Stock Classes of Stock Most companies issue just one class of stock. However, some companies have two or more classes of shares outstanding. They differ in their right to vote and/or to receive dividends. Often these classes of shares will be labelled Class A, Class B, etc. Common shares without full voting rights are called restricted shares. There are various types of restricted shares: Non-voting (nv)shares have no vote at all. Subordinated voting (sv) shares have fewer votes per share than another class of common shares. Multiple voting (mv)shares carry multiple votes.
Semih Yildirim ADMS Common Stock Corporate Governance The shareholders may own the company, but they usually do not manage it. Generally, management is delegated to a team of professionals. Though the details of corporate governance vary somewhat, this principal of separation of ownership and control of a firm is found around the world. In Chapter 2 you learned separation of ownership and control creates potential conflict between the shareholders (owners) and their agents (the managers). Several mechanisms have evolved to mitigate this conflict: The Board oversees management and can fire them. Management remuneration can be tied to performance. Poorly performing firms may be taken over and the managers replaced by a new team.
Semih Yildirim ADMS Preferred Stock Preferred Equity Preferred stock takes priority over common stock in regard to dividends. It also ranks ahead of the common shareholders in the distribution of assets if the firm goes bankrupt. Preferred equity is like debt in that it promises a series of fixed payments to investors. It is rare for these payments not to be paid in full and on time. Like common stock, the preferred dividend is paid at the discretion of the Board. Thus, if there are cash flow problems, the preferred dividend, unlike interest payments, may be skipped. The only obligation is that no common dividends can be paid if the preferred dividend has not been paid. The net worth of a company is equal to the book value of its common equity plus preferred stock. For most companies, preferred stock is much less important than common stock in the firm’s capital structure. Like common shares, there is more than one type of preferred share available.
Semih Yildirim ADMS Preferred Stock Types of Preferred Equity Cumulative Preferred Shares If the preferred dividend is not paid, it will be in arrears. All such past dividends accrue. In such a situation, a firm may not pay the common dividend until all preferred dividends in arrears have been paid. Non-Cumulative Preferred Shares If the preferred dividend is not paid, it does not go into arrears and is lost forever. Redeemable Preferred Shares A company has the right to repurchase these shares from the shareholders at a pre-specified price. This price is known as the call price. Retractable Preferred Shares The investor can force the company to buy back his/her shares at a specified date. Convertible Preferred Shares May be converted into another type of security, usually common shares.
Semih Yildirim ADMS Preferred Stock Types of Preferred Equity Floating Rate Preferred Shares Most preferreds, like debt, make fixed payments. So, like debt, the price of a preferred will fluctuate with interest rates. Its value falls as interest rates rise and vice versa. Some preferreds have their dividend linked to interest rates. Any change in interest rates is offset by a change in the dividend, thus protecting the market value of the investment.