Consider the following preferred stock:
Price per share: $12.55 -
Semiannual dividend per share: $0.725
Required return: 11.50% 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? (Assume a long-term holding period).
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A. B. C. D. E. F.A
The preferred stock profiled in this example is trading very close to its theoretical value, which is found as $12.61.
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 a semiannual figure, which must be doubled to show the annual dividend. After this adjustment has been made, the value of the preferred stock can be found as follows.
{P0 = [$1.45 / 0.115] = $12.61.
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.