Valuing preferred stock: dividend yield, earnings and equity are key to the process.EXECUTIVE SUMMARY * 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 privately held company A firm whose shares are held within a relatively small circle of owners and are not traded publicly. , too. CPA/ABVs may be engaged to value preferred stock Stock shares that have preferential rights to dividends or to amounts distributable on liquidation, or to both, ahead of common shareholders. Preferred stock is given preference over common stock. Holders of preferred stock receive dividends at a fixed annual rate. (also called preferred shares Preferred shares Preferred shares give investors a fixed dividend from the company's earnings and entitle them to be paid before common shareholders. See: Preferred stock. ) to assist with capitalization capitalization n. 1) the act of counting anticipated earnings and expenses as capital assets (property, equipment, fixtures) for accounting purposes. 2) the amount of anticipated net earnings which hypothetically can be used for conversion into capital assets. 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 Tax planning Devising strategies throughout the year in order to minimize tax liability, for example, by choosing a tax filing status that is most beneficial to the taxpayer. , or many other reasons. * 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 earnings. * To value a business having both common and preferred shares, CPAs should value the preferred shares first and deduct de·duct v. de·duct·ed, de·duct·ing, de·ducts v.tr. 1. To take away (a quantity) from another; subtract. 2. To derive by deduction; deduce. v.intr. that value from the entire equity of the entity. * CPAs should 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 Hypothetical is an adjective, meaning of or pertaining to a hypothesis. See:
********** 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 con·fer v. con·ferred, con·fer·ring, con·fers v.tr. 1. To bestow (an honor, for example): conferred a medal on the hero; conferred an honorary degree on her. by common stock. Preferred shareholders may have an advantage over common stock shareholders in dissolution Act or process of dissolving; termination; winding up. In this sense it is frequently used in the phrase dissolution of a partnership. The dissolution of a contract is its Rescission by the parties themselves or by a court that nullifies its binding force and reinstates each , bankruptcy or liquidation The collection of assets belonging to a debtor to be applied to the discharge of his or her outstanding debts. A type of proceeding pursuant to federal Bankruptcy , 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 shams 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 Estate Planning The overall planning of a person's wealth, including the preparation of a will and the planning of taxes after the individual's death. Notes: Contrary to popular belief, estate planning involves much more than preparing a will, and it is not only for the purposes. The value of a share of preferred stock is derived from the following formula: Value of preferred share = Dividend (future income stream) / Required dividend yield (required rate of return) 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 A person selected or appointed by a competent authority or an interested party to evaluate the financial worth of property. Appraisers are frequently appointed in probate and condemnation proceedings and are also used by banks and real estate concerns to determine the market 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 VICE VERSA. On the contrary; on opposite sides. . 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 Voting rights The right to vote on matters that are put to a vote of security holders. For example the right to vote for directors. voting rights The type of voting and the amount of control held by the owners of a class of stock. and other similar terms would be the ideal comparable for determining the yield required in arm's length transactions Arm's Length Transaction A transaction in which the buyers and sellers of a product act independently of each other and have no relationship to each other. Notes: Such a transaction is absent of any pressure sales tactics or relationships among the various parties. for closely held A phrase used to describe the ownership, management, and operation of a corporation by a small group of people. In a closely held corporation, the same people often act as shareholders, directors, and officers, and no outside investors exist. stock." The 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 COMPULSION. The forcible inducement to au act. 2. Compulsion may be lawful or unlawful. 1. When a man is compelled by lawful authority to do that which be ought to do, that compulsion does not affect the validity of the act; as for example, when a court of 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 STOCK When comparing characteristics of preferred shares to characteristics of similar securities, look at the following: * Dividend rate. What amount of income is received periodically? * Cumulative vs. noncumulative. Will dividends accrue To increase; to augment; to come to by way of increase; to be added as an increase, profit, or damage. Acquired; falling due; made or executed; matured; occurred; received; vested; was created; was incurred. if they are not paid on time, or is the dividend lost if the company is unable to, or decides not to, pay it? * Participating vs. nonparticipating. Is there a right to participate in earnings or value over and above the stated rate? * Liquidation preference. Will preferred shareholders receive a distribution upon liquidation before the common shareholders? * Redeemable Redeemable Eligible for redemption under the terms of an indenture. vs. 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 sinking fund, sum set apart periodically from the income of a government or a business and allowed to accumulate in order ultimately to pay off a debt. A preferred investment for a sinking fund is the purchase of the government's or firm's bonds that are to be paid , 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 redeem v. to buy back, as when an owner who had mortgaged his/her real property pays off the debt. The term also refers to paying the amount due and all charges after a foreclosure (due to failure to make payments when due) has begun. the preferred shares. * Voting vs. 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 such rights. * Put options. Can a shareholder make the company repurchase re·pur·chase tr.v. re·pur·chased, re·pur·chas·ing, re·pur·chas·es To buy (something) again. n. The act of buying something that one previously sold or owned. Noun 1. the shares for a fixed price (usually par value)? * Convertible vs. nonconvertible. Can the shares be converted for common stock, or into some other stock or debt instrument? Each specific characteristic affects value based on the advantage or disadvantage associated with it. See exhibit 1, page 57, for more on how each characteristic affects value. 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. The factors 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. Exhibit 2, page 57, 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 debt-to-equity ratio The relationship between long-term funds provided by creditors and funds provided by owners. A firm's debt-to-equity ratio is calculated by dividing long-term debt by owners' equity. Both items are shown on the balance sheet. , the return on equity and the pretax pre·tax adj. Existing before tax deductions: pretax income. pretax adj [profit] → vor (Abzug der) Steuern return on total capitalization Total capitalization The total long-term debt and all types of equity of a company that constitutes its capital structure. total capitalization See capitalization. . Exhibit 3, page 58, offers formulas for calculating those ratios. 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 Net assets The difference between total assets on the one hand and current liabilities and noncapitalized long-term liabilities on the other hand. net assets See owners' equity. 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 The 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 preferred dividend preferred dividend n. a payment of a corporation's profits to holders of preferred shares of stock. (See: preferred stock) . 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 rights. Exhibit 4, page 58, shows a model of how to summarize sum·ma·rize intr. & tr.v. sum·ma·rized, sum·ma·riz·ing, sum·ma·riz·es To make a summary or make a summary of. sum those factors. Also look at the same types of factors you would use when determining company-specific risk Company-specific risk Related: Unsystematic 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 industry. * The depth and competence of company management. * Proposed federal regulation of the business. * The rights of lenders and other shareholders to influence the dividend policy * Trends in and diversification Diversification A risk management technique that mixes a wide variety of investments within a portfolio. It is designed to minimize the impact of any one security on overall portfolio performance. Notes: Diversification is possibly the greatest way to reduce the risk. of supply sources. * Trends in diversification of revenue sources. 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 The 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. If the 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 considerations. 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 es·o·ter·ic adj. 1. a. Intended for or understood by only a particular group: an esoteric cult. See Synonyms at mysterious. b. 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. Reliable Returns Preferred shores pay a fixed quarterly dividend based on o stated par value. If XYZ XYZ interj. Informal Used to indicate to someone that the zipper of his or her pants is open. [ex(amine) y(our) z(ipper).] Corp. issues a preferred stock with a par value of $50 and paying a quarterly 2% dividend, that's a $1 dividend each quarter. Source; www.riskglossary.com/link/preferred_stock.htm AICPA AICPA See American Institute of Certified Public Accountants (AICPA). RESOURCES Web site Business Valuation and Forensic Belonging to courts of justice. forensic 1) adj. from Latin forensis for "belonging to the forum," ancient Rome's site for public debate, and currently meaning pertaining to the courts. and Litigation An action brought in court to enforce a particular right. The act or process of bringing a lawsuit in and of itself; a judicial contest; any dispute. When a person begins a civil lawsuit, the person enters into a process called litigation. Services Community, http://bvfls.aicpa.org/Resources. Publications * Business Valuation Review, a publication of the American Society of Appraisers, www.bvappraisers.org. * Financial Analysts Journal, a publication of the Association for Investment, Management and Research, www.cfapubs.org/ loi/faj. * Revenue ruling 59-60, "Gleaning Harvesting for free distribution to the needy, or for donation to a nonprofit organization for ultimate distribution to the needy, an agricultural crop that has been donated by the owner. IRS An abbreviation for the Internal Revenue Service, a federal agency charged with the responsibility of administering and enforcing internal revenue laws. Guidance," AICPA, The Practicing CPA (Computer Press Association, Landing, NJ) An earlier membership organization founded in 1983 that promoted excellence in computer journalism. Its annual awards honored outstanding examples in print, broadcast and electronic media. The CPA disbanded in 2000. , December 2002, www.aicpa.org/pubs/ tpcpa/dec2002/gleaning.htm. * Revenue ruling 83-120, Internal Revenue Service, www.taxlinks.com/rulings/ 1983/revru183-120.htm. * Valuing a Business, 4th Edition, by Shannon P. Pratt, Robert F. Reilly and Robert P. Schweihs, McGraw-Hill, 2000. Scott E. Miller, CPA, CVA CVA abbr. cerebrovascular accident CVA, n See accident, cerebrovascular. CVA cerebrovascular accident. CVA Cerebrovascular accident, see there , 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 ethics committee A multidisciplinary hospital body composed of a broad spectrum of personnel–eg, physicians, nurses, social workers, priests, and others, which addresses the moral and ethical issues within the hospital. See DNR, Institutional review board. . He currently resides in Virginia Beach Virginia Beach, resort city (1990 pop. 393,069), independent and in no county, SE Va., on the Atlantic coast; inc. 1906. In 1963, Princess Anne co. and the former small town of Virginia Beach were merged, giving the present city an area of 302 sq mi (782 sq km). , Va. His e-mail address See Internet address. e-mail address - electronic mail address is gmvb@cox.net.
Exhibit 1 How Each Characteristic
May Affect the Value
Characteristic Increases value Decreases value
Convertible vs. nonconvertible Convertible Nonconvertible
Cumulative or noncumulative Cumulative Noncumulative
Fixed dividend rate Rate [greater than Rate < Mkt
or equal to] Mkt
Adjustable dividend rate Usually No
Liquidation preference Yes No
Participating vs. Participating Nonparticipating
nonparticipating
Put option Yes No
Redeemable vs. nonredeemable Call price high Call price low
and/or callable and/or callable
long term soon
Voting vs. nonvoting Voting Nonvoting
Exhibit 2 Nonconvertible, Cumulative Fixed Rate
Preferred Stock Yields and Analysis
Dividend Yield
Range Dividend Yield
S&P No. of No. of
Rating Companies Issues Low % High % Mean % Median %
Subject 7.5 7.5 7.5 7.5
AA- 1 1 8.5 8.5 8.5 8.5
A+ 2 2 7.9 8.4 8.2 8.2
A 8 11 6.2 9.5 8.3 8.3
A- 12 13 5.6 8.9 7.8 8.0
BBB+ 17 19 6.6 9.5 8.4 8.4
BBB 9 9 8.1 11.2 9.1 8.6
BBB- 12 16 6.1 10.1 8.7 8.6
BB+ 16 18 0.6 10.7 8.8 9.2
BB 6 6 8.6 9.5 9.2 9.4
B+ 1 2 9.6 10.5 10.1 10.1
B 2 2 13.4 14.6 14.0 14.0
NR 34 35 0.8 18.7 9.7 9.4
Averages
S&P Fixed Chg. Interest Liquidation
Rating Ratio Coverage Coverage
Subject 1.03 1.7 2.50
AA- 2.53 5.5 7.00
A+ 3.38 5.4 13.00
A 2.00 3.4 4.13
A- 1.93 3.1 7.00
BBB+ 1.95 2.7 5.80
BBB 1.21 1.6 5.40
BBB- 1.20 2.1 3.00
BB+ 1.04 1.8 5.00
BB 0.72 1.2 2.22
B+ 0.56 1.0 3.33
B 0.56 0.9 5.00
NR 0.90 1.3 5.67
Averages
S&P Debt to Return On Return On
Rating Equity Equity Capitalizatn
Subject 0.80 11.7% 6.5%
AA- 0.31 7.1% 5.4%
A+ 0.34 7.2% 5.4%
A 0.91 12.1% 6.3%
A- 0.64 7.1% 4.3%
BBB+ 1.10 12.1% 5.7%
BBB 1.30 10.0% 4.4%
BBB- 1.17 10.0% 4.6%
BB+ 1.00 5.3% 2.7%
BB 1.80 9.5% 3.4%
B+ 1.05 5.0% 2.4%
B 0.80 5.0% 2.8%
NR 1.06 6.8% 3.3%
Portions Adapted from Exhibits 24-5 and 24-6 in "Valuing a Business,"
4th Edition
Source: Copyright [c] 2005, Scott E. Miller, CPA, CVA.
Exhibit 3
Ratio Formulas Yield
Information
Fixed-charge ratio
Earnings before interest and taxes (EBIT)/
Interest+[(preferred dividends) / 1-(effective tax rate)]
Interest-coverage ratio
Earnings before interest and taxes/
Annual interest expense
Liquidation-coverage ratio
(Market value of assets) - (Market value of liabilities)/
Liquidation value of preferred stock
Dept-to-equity ratio
Total debt/
Total equity
Returns on equity
Earnings before interest and taxes/
Total equity
Pretax return on total capitalization
Earnings before interest and taxes/
Total debt + total equity
Exhibit 4 Subject Company Preferred
vs. Similar Public Securities
How they compare
Characteristic ABC Co. Similar Better or worse?
Dividend yield 7.5% 9.2% Worse
Cumulative Yes Yes No difference
Fixed rate Yes Yes No difference
Convertible No No No difference
Redeemable Yes Yes No difference
Put option Yes No Somewhat better
Voting No Yes Worse
Liquidation preference Yes No Somewhat better
Participating No No No difference
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