The liquidation value of preferred stock can depend on several factors, including the total value of the company at the time of liquidation. An important factor to remember is that owners of preferred stock must be the first paid upon liquidation of a company.

Overview of Liquidation Value

Although most companies are separate entities from their owners, it's important to remember that companies are not real people. In particular, this means that a company can exist for hundreds of years without much difficulty. Many circumstances exist, however, where a company would need to shut down. The company's management or ownership can decide that it's time for the company to end, or the company can end because of bankruptcy.

Liquidation is the process of ending a company's business and dissolving the company. During liquidation, the assets of the company get distributed among several groups and individuals:

  • Shareholders
  • Lenders
  • Creditors

The amount that these groups will receive and the order in which they get paid will depend on the security of their claim. When someone says liquidation value, they simply mean the total value of the tangible assets of a company when the company ends. Both fixed and current assets are considerations when determining a company's liquidation value.

What is Preferred Stock?

Many companies offer different classes of ownership, including preferred stock. At one point in time, only large companies issued preferred stock, but now small companies have started to make use of this ownership class. The owners of preferred stock have priority over the owners of common stock.

Valuating preferred stock can help a company with several important tasks:

  • Capitalization
  • Business sales or mergers
  • Reorganizations due to bankruptcy

Preferred stocks have both debt and equity characteristics. Most preferred stocks possess a dividend requirement, which can make them appear as debt. The dividend requirement of preferred stocks also includes some rights, including the enterprise earnings participation.

Preferred Stock Valuation

Determining the value of preferred stock can be much different than calculating the value of common stock. The main reason that preferred stock valuation can be tough is that preferred stocks have characteristics of both bonds and stocks. Just like owners of common stock, people that own preferred stock are partial owners of the company that issued the stock. The stockholder's ownership stake in the company will be proportional to the number of stocks that they own.

The reason that preferred stocks are similar to bonds is that both involve a fixed payment. With preferred stock, the fixed payment takes dividend form, and you can use this dividend to calculate the value of the preferred stock. Depending on the company's policy, dividends can be paid monthly, quarterly, or annually.

A unique feature of preferred stocks is that these stocks have a priority claim on a company's assets. If a company goes bankrupt, for instance, preferred stockholders will get paid before common stockholders. It's important to remember, however, that if a company ends due to bankruptcy, paying creditors is the priority over paying preferred and common stockholders. Preferred stockholders also take precedence in terms of dividend payments. For instance, if a company's management decides that it's not possible to make a full dividend payment due to a lack of earnings, whatever payments are possible will go to preferred stockholders.

Another unique feature of preferred stocks is that they have a fixed dividend, meaning it's possible to valuate a preferred stock by discounting dividend payments. With common stock, dividends are not fixed. Let's assume that a preferred stock requires a monthly $0.25 dividend payment and that there is a six percent required rate of return each year.

In this scenario, the expected value of the stock would be $50. This calculation is reached by first dividing the return rate of six percent by 12, which would be 0.005, and then dividing the $0.25 dividend payment by this amount.

Certain considerations involving preferred stocks must be taken into account. For instance, while preferred stocks do require a dividend payment, it's possible that this payment will be reduced if the company cannot accommodate a full distribution. The risk for a decreased dividend payment is substantial if there is a high payment ratio, which refers to the required dividend payment compared to the company's earnings.

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