Preferred Stock Valuation: Overvalued, Undervalued, or Correctly Valued?

Preferred Stock Valuation

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Question

Consider the following preferred stock issued by Bluebook Pharmaceuticals:

Price per share: $12.65 -

Annual dividend per share: $1.30

Required rate of return: 9% per year

Is the preferred stock realistically overvalued, undervalued, or correctly valued? Further, should this preferred stock be valued as a perpetuity or a finite series of cash flows?

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Explanations

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A

The preferred stock profiled in this example is trading above its theoretical value, which is found to be $14.44.

To determine the value of a preferred stock, use the following equation: {P0 = [d1 / k]}

Where:P0 = the price of the preferred stock at time 0, d1 = the annual dividend at t = 1, and k = the required rate of return.

In this example, the dividend is provided as an annual figure, so all of the necessary information has been given. The calculation of the value of this preferred stock is as follows:

{P0 = [$1.30 / 0.09] = $14.44

Preferred stock is commonly valued as a perpetuity because there is no finite conclusion to the projected series of cash flows for a preferred stock. Unlike a bond, whose cash flows are characterized by a finite lifespan (i.e. the cash flows of a bond cease at maturity), the cash flows (dividends) produced by a preferred stock could theoretically last forever.

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