Academic journal article Journal of Accountancy

Valuing Preferred Stock: Dividend Yield, Earnings and Equity Are Key to the Process

Academic journal article Journal of Accountancy

Valuing Preferred Stock: Dividend Yield, Earnings and Equity Are Key to the Process

Article excerpt

EXECUTIVE SUMMARY

* Preferred stock--a class of ownership with priority over common stock--once was issued mainly by large companies but now is common in small to midsize privately held companies, too. CPA/ABVs may be engaged to value preferred stock (also called preferred shares) to assist with capitalization of a company, bankruptcy reorganizations, a business merger or sale, exchanging preferred shares for debt or other types of equity securities, gift or estate tax planning, or many other reasons.

* Preferred stock has characteristics of both equity and debt. Preferred shares generally have a dividend requirement that makes them appear similar to debt. The dividend structure usually has rights attached to it, such as whether the shares participate in enterprise earnings.

* To value a business having both common and preferred shares, CPAs should value the preferred shares first and deduct that value from the entire equity of the entity.

* CPAs should determine the required dividend yield by performing an analysis similar to a market-based approach and comparing the preferred stock's dividend rate with that of a publicly traded stock. If the preferred stock has a lower yield than the publicly traded stock, it would sell below par value in order to raise the effective yield; if it has a higher yield, it would sell above par value.

* The value of any investment is influenced by two significant factors: the amount of income or cash flow the entity generates and the risk to a hypothetical willing buyer aware of all relevant facts. The characteristics of the security, the differences between common and preferred stock and the motivations of investors in each type of security are key in the appraisal.

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Preferred stock--a class of ownership with priority over common stock--once was issued mainly by large companies; now it has become more common in small to midsize privately held companies as well. Clients may need valuation analysts such as CPA/ABVs to value preferred stock (also called preferred shares) to assist with capitalization of a company, bankruptcy reorganizations, business mergers or sales, exchanging preferred shares for debt or other types of equity securities, gift or estate tax planning, or many other reasons. Here's some basic information about the proper methods for valuing preferred stock.

WHAT IS PREFERRED STOCK?

Preferred stock is an element of shareholder equity that has characteristics of both equity and debt. A preferred share carries additional rights above and beyond those conferred by common stock. Preferred shareholders may have an advantage over common stock shareholders in dissolution, bankruptcy or liquidation, for instance. Preferred shares also generally have a dividend requirement, which makes them appear similar to debt. The dividend structure usually has rights attached to it, such as whether the dividends are cumulative or whether the shams participate in enterprise earnings. The dividend rate may or may not be fixed or tied to some type of index that controls the movement of the rate, either up or down.

EXISTING AUTHORITATIVE GUIDANCE

Authoritative guidance for the valuation of preferred stock is somewhat limited. Revenue ruling 83-120, issued to enhance the guidance from revenue ruling 59-60, is the main source. Section 4.01 states the most important factors in determining the value of preferred stock are its yield and dividend coverage and the payment protection of its liquidation preference. This guidance was created mainly for valuations applicable to gift and estate planning purposes.

The value of a share of preferred stock is derived from the following formula:

Value of preferred share = Dividend (future income stream) / Required dividend yield (required rate of return)

The dividend is the easy part, as it is the stated rate; the required dividend yield takes more work to find. …

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