What is Cost of Preferred Stock?
The Cost of Preferred Stock represents the rate of return required by preferred shareholders and is calculated as the annual preferred dividend paid out (DPS) divided by the current market price.
Considered a “hybrid” form of financing, preferred stock is a blend between common equity and debt – but is broken out as a separate component of the weighted average cost of capital (WACC) calculation.
How to Calculate Cost of Preferred Stock?
The cost of preferred stock represents the dividend yield on the preferred equity securities issued, the cost of preferred stock is equal to the preferred stock dividend per share (DPS) divided by the issuance price per preferred share.
The recommended modeling best practice for hybrid securities such as preferred stock is to treat it as a separate component of the capital structure.
But one common point of confusion is the following question, “Why should preferred stock be separated from equity and debt in the first place?”
Preferred equity is not quite debt capital nor is it common equity, so it has unique attributes that warrant it being a separate input in the WACC formula.
The cost of preferred equity, barring unusual circumstances, typically does not have a material impact on the ultimate firm valuation.
Therefore, if the preferred equity amount is minuscule, it could be lumped together with debt, and the net impact on the valuation is going to be marginal. Nevertheless, a company’s preferred stock must still be properly accounted for in the firm valuation.
Cost of Preferred Stock Formula
The formula for calculating the cost of preferred stock is the annual preferred dividend payment divided by the current share price of the stock.
Hence, the cost of preferred stock is analogous to the perpetuity formula as used in the valuation of bonds and debt-like instruments.
As for the dividend per share (DPS), the amount is ordinarily specified as a percentage of the par value or as a fixed amount.
In this case, we are assuming the most straightforward variation of preferred stock, which comes with no convertibility or callable features.
The value of preferred stock is equal to the present value (PV) of its periodic dividends (i.e. the cash flows to preferred shareholders), with a discount rate applied to factor in the risk of the preferred stock and the opportunity cost of capital.
Upon re-arranging the formula, we can arrive at the formula in which the cost of capital (i.e. discount rate) of the preferred stock is equal to the preferred DPS divided by the current price of the preferred stock.
If dividend growth is expected, then the following formula would be used instead:
In the numerator, we project the growth in the preferred stock DPS for one year using the growth rate assumption, divide the projected DPS by the price of the preferred stock, and then add the perpetual rate (g), which refers to the anticipated growth in the preferred DPS.
Cost of Preferred Stock Calculation Example
Let’s say a company has issued “vanilla” preferred stock, on which the company issues out a fixed dividend of $4.00 per share.
If the current price of the company’s preferred stock is $80.00, then the cost of preferred stock is equal to 5.0%.
- Cost of Preferred Stock = $4.00 ÷ $80.00 = 5.0%
Cost of Preferred Stock vs. Cost of Equity: What is the Difference?
In the capital structure, preferred stock sits in between debt and common equity – and these are the three key inputs for the cost of capital (WACC) calculation.
All debt instruments – regardless of the risk profile (e.g. mezzanine debt) – are of higher seniority than preferred stock.
On the other hand, preferred stock is senior to common stock and a company cannot legally issue a dividend to common shareholders without also issuing dividends to preferred shareholders.
Most preferred stock is issued without a maturity date, as mentioned earlier (i.e. with perpetual dividend income). However, note that there are instances when companies issue preferred stock with a fixed maturity date.
Additionally, unlike the interest expense associated with debt capital, the dividends paid on preferred stock are NOT tax-deductible, as with common dividends.
Nuances to the Cost of Preferred Equity
Sometimes, preferred stock is issued with additional features that ultimately impact its yield and the cost of the financing.
For instance, preferred stock can come with call options, conversion features (i.e. can be converted into common stock), cumulative paid-in-kind (PIK) dividends, and more.
Discretion is required in such cases, as there is no precise methodology for treating these features due to the amount of uncertainty that cannot all be accounted for when estimating the cost of the preferred stock.
Based on the most probable outcome, which is highly subjective, you’ll need to make adjustments as seen fit – e.g. when dealing with preferred equity with convertible features, the security could be broken into separate debt (straight-debt treatment) and equity (conversion option) components.
Cost of Preferred Stock Calculator
We’ll now move on to a modeling exercise, which you can access by filling out the form below.
1. Preferred Stock Dividend Growth Rate Assumptions
In our modeling exercise, we’ll be calculating the cost of preferred stock (rp) for two different dividend growth profiles:
- Zero Growth in Dividend Per Share (DPS)
- Perpetual Growth in Dividend Per Share (DPS)
For each scenario, the following assumptions will remain constant:
- Preferred Stock Dividend Per Share (DPS) = $4.00
- Current Price of Preferred Stock = $50.00
2. Zero Growth Cost of Preferred Stock Calculation Example
In the first type of preferred stock, there is no growth in the the dividend per share (DPS).
Therefore, we enter our numbers into the simple cost of preferred stock formula to get the following:
- kp, Zero Growth = $4.00 / $50.00 = 8.0%
3. Growth Cost of Preferred Stock Calculation Example
As for the next type of preferred stock, which we’ll compare to the prior section, the assumption here is that the dividend per share (DPS) will grow at a perpetual rate of 2.0%.
The formula used to calculate the cost of preferred stock with growth is as follows:
- kp, Growth = [$4.00 * (1 + 2.0%) / $50.00] + 2.0%
The formula above tells us that the cost of preferred stock is equal to the expected preferred dividend amount in Year 1 divided by the current price of the preferred stock, plus the perpetual growth rate.
Since the preferred stock is expected to grow at a fixed growth rate, which is 2.0% in our example, the cost of preferred stock is higher than in the case with zero DPS. Here, a rational investor should expect a higher rate of return, which would directly impact the pricing of the shares.