| 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
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
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
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.
Scott E. Miller, CPA,
CVA, was formerly the president of
Forensic Analytics in Portland, Ore.
Mr. Miller served on the AICPA Task
Force for Establishing Standards for
Litigation and participated on several
ethics committees. He currently
resides in Virginia Beach, Va. His
e-mail address is
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 shares 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:
Dividend (future income stream) |
Required dividend yield (required rate
The dividend is the easy part, as it is the
stated rate; the required dividend yield takes
more work to find. To determine the required
dividend yield, the appraiser needs to perform an
analysis similar to a market-based approach.
Section 4.02 of revenue ruling 83-120 says, “The
adequacy of the dividend rate should be determined
by comparing its dividend rate with the dividend
rate of high-grade publicly traded preferred
stock.” If the subject security has a lower yield
than the high-grade publicly traded preferred
stock you compare it with in your analysis, the
security would sell below par value in order to
raise the effective yield, and vice versa.
Section 4.02 goes on to say, “A publicly traded
preferred stock for a company having similar
business and similar assets with similar
liquidation preferences, voting rights and other
similar terms would be the ideal comparable for
determining the yield required in arm’s length
transactions for closely held stock.”
value of any investment is directly influenced by
two significant factors: the amount of income or
cash flow generated by the entity and the risk to
a hypothetical willing buyer (not under a
compulsion to buy and aware of all the relevant
facts) who would purchase the shares (invest). The
process of determining the value of preferred
stock is not entirely different from common stock,
except the risk is assessed based on the
individual characteristics of the preferred shares
and their impact on the income or cash flow.
Note: Appraisers who value a business having
both common and preferred shares must value the
preferred shares first, deducting that value from
the total equity of the enterprise before valuing
the common shares.
CHARACTERISTICS OF PREFERRED
characteristics of preferred shares to
characteristics of similar securities, look at the
Dividend rate. What amount
of income is received periodically?
dividends accrue if they are not paid on time, or
is the dividend lost if the company is unable to,
or decides not to, pay it?
nonparticipating. Is there
a right to participate in earnings or value over
and above the stated rate?
Will preferred shareholders receive
a distribution upon liquidation before the common
nonredeemable. Do the
preferred shares have a fixed term, and can they
be bought back by the company at a specified
price, time or interval? Redeemable shares may
have a sinking fund, a cache into which the
company pays over time to fund retiring them. The
most important provisions regarding redemption are
the call price and the length of time until the
company will redeem the preferred shares.
nonvoting. Do the
preferred shares come with voting rights? Common
stock lets holders participate in running the
company; special classes of shares may not have
Put options. Can a
shareholder make the company repurchase the shares
for a fixed price (usually par value)?
nonconvertible. Can the
shares be converted for common stock, or into some
other stock or debt instrument?
specific characteristic affects value based on the
advantage or disadvantage associated with it. See
exhibit 1 for more on how each characteristic
Characteristic May Affect the
||Rate > Mkt
||Rate < Mkt
||Call price high
and/or callable long
price low and/or
callable soon |
PERFORM AN ANALYSIS
Locating the information necessary to
perform an analysis can be a challenge (see “ Signed,
Sealed, Delivered, ” JofA, Nov.02,
page 30). Besides the qualitative factors that
influence a security’s rating, the industry
outlook and economy also affect a company’s
preferred stock income-stream risk. In addition,
characteristics that affect value or risk do not
all carry the same weight.
that affect value the most are
Whether the dividend yield is above
or below market.
Whether the company can pay its
dividend from earnings.
Whether there is sufficient equity to
fully pay preferred shareholders at liquidation.
Cumulative Fixed Rate Preferred
Stock Yields and
|| || || |
Adapted from Exhibits
24-5 and 24-6 in
“Valuing a Business,”
4th Edition |
Copyright @ 2005, Scott
E. Miller, CPA, CVA.
Exhibit 2 illustrates how to determine whether
the yield is above or below market. The ratios
shown include the fixed-charge ratio,
interest-coverage ratio, liquidation-coverage
ratio, debt-to-equity ratio, the return on equity
and the pretax return on total capitalization.
Exhibit 3 offers formulas for calculating those
before interest and
[(preferred dividends) ÷
1 – (effective tax
before interest and
value of assets) –
(Market value of
of preferred stock
before interest and
return on total
before interest and
Total debt + total
INTERPRET THE RESULTS
The fixed-charge ratio is used to assess the
risk that the dividend will no longer be viable;
the higher the ratio, the better the company’s
financial condition and the lower the risk. The
interest-coverage ratio is useful in evaluating
the ability of the company to generate sufficient
profits over and above its interest requirements.
The liquidation-coverage ratio provides a measure
for the amount of net assets available to common
and preferred shareholders after the payment of
all debts. The debt-to-equity ratio is useful in
analyzing the amount of financial risk in its
capital structure; the lower the ratio, the less
debt and the healthier the company.
return-on-equity ratio is useful in measuring the
operational performance of an entity. A higher
ratio generally reflects a better run and more
profitable enterprise. Under some circumstances
this ratio may yield misleading results, however,
so use it only in conjunction with other analyses.
For example, the
pretax-return-on-total-capitalization ratio can be
a useful measure of profitability; the higher the
ratio, the greater the ability to pay the
Other factors to
consider when evaluating preferred stock include
Whether the dividends are cumulative.
Whether the shares participate in
additional earnings or equity.
Whether particular covenants exist
that might reduce the marketability of the shares.
Whether there is a put option.
What redemption privileges exist (for
example, high call prices and more time until it
can be called increase the value).
Whether the shares have voting
Exhibit 4 shows a model of how to
summarize those factors.
Preferred vs. Similar Public
||Better or worse?
Also look at the same types of factors you
would use when determining company-specific risk
factors for building a capitalization or discount
rate. Gerald Martin and E. Halsey Sandford listed
six additional factors in their March 1991
Business Valuation Review article
“Valuation of Preferred Stock.” They are
The competitive environment in the
The depth and competence of company
Proposed federal regulation of the
The rights of lenders and other
shareholders to influence the dividend policy.
Trends in and diversification of
Trends in diversification of revenue
To apply those factors, Martin
and Sandford say, “Select an appropriate yield
that reflects not only public market conditions at
the valuation date (‘systematic risk’), but also
the prospects of the company at the time
(‘fundamental risk’ of success or failure).” That
is, look at all factors that could affect the risk
associated with the preferred stock.
DISCOUNTS AND PREMIUMS
final step is to determine whether any discounts
or premiums apply to the preferred securities
being valued. Normally, discounts and premiums
that might apply to common shares do not apply to
preferred shares or are taken into account when
comparing the subject shares to similar
securities, as shown in exhibits 1 through 4. The
reason for this is the factors normally associated
with discounts or premiums on common stock are
more closely linked to the “total” returns
generated from the security (that is, appreciation
and income) while returns on preferred shares are
generated mostly from the income returns, as they
are more like debt securities than equity
securities. Before applying any such discount or
premium, the appraiser should consider these as
well as any other differences.
appraiser believes a discount or premium is
necessary, either increase the appropriate yield
to apply to the preferred stock’s dividends or
take a discount from the value determined by
applying a yield unadjusted for marketability
PRODUCTS, SCOPE, SKILLS
When valuing preferred stock,
CPA/ABVs should keep in mind that the
characteristics of the security, the differences
between common and preferred stock and the
motivations of investors in each type of security
are key. They should become familiar with revenue
ruling 83-120 as an important first step, and
identify the characteristics of the subject shares
and compare them with those of similar
high-quality publicly traded securities. After
careful analysis and examination, CPAs should use
their best judgment to determine the yield an
investor would require to consider purchasing the
subject shares and adjust the value of the subject
preferred shares based upon that required yield.
Valuation of preferred stock was once an
esoteric art, but the world of business finance
has changed. Having the knowledge to perform a
preferred stock valuation can increase a CPA/ABV’s
scope to accept engagements he or she would at one
time have found much harder to perform.