The Difference Between Valuing Preferred Stock and Common Stock and Their Calculation
Preferred and common stock share similar traits: they do not have maturity dates, failure to pay dividends does not lead to bankruptcy, and dividends are not deductible for tax purposes. However, the calculation of the value of preferred stock varies from that of common stock due to differences in the considered factors.
The valuation of preferred stock is based on the dividend divided by the required rate of return. It differs from the valuation for common stock, which considers more factors (Keown et al., 2020). Calculating standard stock value requires dividing the net income by the sum of the common stock and retained earnings (Keown et al., 2020). As evident, preferred stock has a more straightforward valuation process, unlike common stock, which requires considering several factors.
Investment in Preferred Stock
The characteristics of preferred stock give it an attractive look that propels one to invest in it. Preferred stock has a priority claim over common stock during dividend payments and liquidation (Keown et al., 2020). Prioritization makes them attractive since they guarantee one return on investment, including avoiding losses when a company fails. Another attractive feature of preferred stocks is that they have a more stable price than common stock, which is a fantastic guarantee. They are also attractive since they offer higher fixed-income payments compared to bonds.
Similarity Between Preferred Stock and Bond
The assumption that placing preferred stock in the same category as bonds is correct. The common traits between them include the priority they are given during payments. While bondholders will be paid first in case of bankruptcy, preferred stockholders will also get paid ahead of common stockholders (Keown et al., 2020). Another similarity is sensitivity to interest rates, where they rise when interest rates fall and vice versa. The only difference between the two is that bonds have a fixed interest rate paid on them, while preferred stocks are paid through calculated dividends.
Reference
Keown, A. J., Martin, J. D., & Petty, J. W. (2020). Foundations of finance: The logic and practice of financial management (10th ed.). Prentice Hall.