Key Takeaways

  • Preferred stock dividends are generally fixed and calculated using the dividend rate and par value; common stock dividends vary based on board decisions.
  • The formula for preferred stock valuation is Dividend ÷ Required Rate of Return, similar to valuing perpetuities.
  • Investors must account for features such as cumulative dividends, call provisions, and conversion rights, which affect both risk and value.
  • Preferred stock often appeals to investors seeking stable income, while common stockholders gain more upside potential and voting rights.
  • The accounting treatment of preferred stock on financial statements varies depending on whether it resembles debt or equity.

Wondering how to calculate preferred stock and common stock? Preferred stock is a type of ownership security or equity that differs from common stock in that it doesn't provide shareholders with voting rights. Preferred stock does pay a fixed dividend when the shares are issued that show up on the stock's prospectus, and that dividend must be paid before dividends from common stock.

How to Calculate Preferred Stock Dividend Distributions

Preferred stock is a special kind of stock traded on the exchange that acts similar to a bond. Like bonds, preferred stocks are usually purchased for their income potential, not necessarily their growth.

For the majority of preferred stocks, a company must pay dividends before paying common stock dividends. Preferred stocks are less risky for investors because they're paid before common stocks if the company runs into financial trouble. As a result, preferred stockholders take priority over common shareholders, but they're still ranked behind bondholders. Even so, preferred stock is a smart investment.

Preferred stocks and bonds are also similar in that dividends never fluctuate despite the stock's changes in market value. Instead, preferred stocks feature a fixed dividend rate passed on the stock's par value, which is generally around $25. Calculating the stock's dividends is a straightforward process, and stockholders can expect to be paid the same dividend amount every quarter.

Check the issuing company's preferred stock prospectus for more information on the stock's dividend rate and par value. Once you locate this information, you can then convert it to a decimal. For example, a 5 percent dividend rate equals 0.05. Once you have the decimal amount, multiply the rate by the stock's par value. To figure out how much you'll earn per quarter, simply divide the answer by four. You can then multiply the number by however many preferred stock shares you own.

Although preferred stock might increase over time, this growth is limited. That's why investors purchase preferred stock for the dividend income. Preferred stock prices do fluctuate with interest rates, but although a stock's prices may fall, its dividend yields tend to increase.

If you're trying to determine whether to invest in preferred stock, compare its dividend yield to the company's bond yields and other stock issues.

Accounting for Preferred Stock on Financial Statements

From an accounting perspective, preferred stock can be treated differently depending on its characteristics. Some preferred shares resemble equity, while others function more like debt. Companies typically record proceeds from preferred stock issuance under the equity section of the balance sheet. However, if the terms include mandatory redemption or fixed maturity, it may be classified as a liability.

When calculating earnings per share (EPS), companies usually deduct preferred dividends before computing net income available to common shareholders. This distinction highlights the priority of preferred holders over common holders.

How to Value Preferred Stock Shares

In addition to calculating dividend payouts, investors often want to know the overall value of a preferred stock. Because preferred stock pays fixed dividends similar to a bond, its value can be estimated using the dividend discount model for perpetuities:

Preferred Stock Value = Dividend ÷ Required Rate of Return

For example, if a share pays a $2 annual dividend and the required return is 8%, its value is $25 ($2 ÷ 0.08). This formula works best for perpetual preferred shares with no maturity date.

It’s important to note that interest rate changes directly impact preferred stock prices. When market interest rates rise, the required rate of return increases, which reduces the calculated value of the preferred share.

Common Stock vs. Preferred Stock

Whether you purchase common stock or preferred stock, you own a piece of the company and have an investment tool at your disposal. The main difference between common and preferred stock is that common stockholders usually have voting privileges at stockholders' meetings, while preferred stockholders do not.

In most cases, owning common stock gives you one vote per the number of shares you own, although this figure varies by company. Some companies grant preferred stockholders one vote per share or even more; it all depends on how the company operates.

Although common stockholders aren't required to receive fixed dividends from the company, preferred stockholders have that privilege. When you own preferred stock, you also have a bigger claim to the company's earnings and assets, which is nice when the business is doing well and distributes excess cash to its investors.

With preferred stock, you can calculate your dividends and know how much to expect at regular intervals, which isn't the case with common stock. With common stocks, the company's board of directors decide when and whether to pay out dividends.

Other characteristics worth noting about preferred stocks include:

  • They are less volatile than common stocks.
  • Their value declines as interest rates rise.
  • They offer bond-like characteristics that lend them a sort of hybrid security between the two investment types.
  • They have a callability feature that allows the issuing company to redeem market shares after they hit a predetermined value, giving investors the chance to earn significant premiums over their initial purchase price.
  • They come with the same transaction costs through brokerage firms as common stock.
  • They are considered a more stable investment because they provide a regular income stream.
  • They can convert to a fixed number of common stock shares.

How much you'll pay for a preferred stock depends on the company issuing the stock. In general, the cost is influenced by both the stock market and the preferred dividends.

Special Features That Affect Preferred Stock Value

Preferred stock may include contractual features that affect its valuation and attractiveness:

  • Cumulative Dividends: If a company skips a dividend, it must pay arrears before resuming payments to common shareholders.
  • Callable Preferred Stock: Issuers may redeem shares at a set price after a certain date, which caps investor upside.
  • Convertible Preferred Stock: Allows holders to convert shares into common stock, offering potential equity upside.
  • Participating Preferred Stock: Provides the right to receive additional dividends if the company achieves profitability beyond a threshold.

These features should always be reviewed in the prospectus, as they directly affect risk and potential return.

Frequently Asked Questions

  1. How do you calculate preferred stock dividends?
    Multiply the dividend rate (as a decimal) by the par value of the stock. Divide by four for quarterly payouts.
  2. How do you calculate the value of preferred stock?
    Use the formula: Annual Dividend ÷ Required Rate of Return. This is similar to valuing a perpetuity.
  3. Are preferred stock dividends guaranteed?
    They are not legally guaranteed, but cumulative preferred stock requires companies to pay skipped dividends before paying common shareholders.
  4. How does preferred stock affect earnings per share (EPS)?
    Preferred dividends are deducted from net income before calculating EPS for common stockholders.
  5. What risks come with preferred stock?
    Risks include interest rate sensitivity, call risk (shares being redeemed early), and limited price appreciation compared to common stock.

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