Valuing Preferred Stock

Dividend yield, earnings and equity are key to the process.

by Scott E. Miller

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, 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 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 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 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 gmvb@cox.net.

referred 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:

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.”

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 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 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 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, 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.

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 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 for more on how each characteristic affects value.

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 > Mkt Rate < Mkt Adjustable dividend rate Usually No Liquidation preference Yes No Participating vs. nonparticipating Participating Nonparticipating Put option Yes No Redeemable vs. nonredeemable Call price high and/or callable long term Call price low and/or callable soon Voting vs. nonvoting Voting Nonvoting

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.

Nonconvertible, Cumulative Fixed Rate Preferred Stock Yields and Analysis       Dividend Yield Range Dividend Yield Averages       S&P Rating No. of Comp- anies No. of Issues Low % High % Mean % Median % Fixed Chg. Ratio Interest Coverage Liquid- ation Coverage Debt to Equity Return On Equity Return On Capitalizatn Subject     7.5 7.5 7.5 7.5 1.03 1.7 2.50 0.80 11.7% 6.5% AA- 1 1 8.5 8.5 8.5 8.5 2.53 5.5 7.00 0.31 7.1% 5.4% A+ 2 2 7.9 8.4 8.2 8.2 3.38 5.4 13.00 0.34 7.2% 5.4% A 8 11 6.2 9.5 8.3 8.3 2.00 3.4 4.13 0.91 12.1% 6.3% A- 12 13 5.6 8.9 7.8 8.0 1.93 3.1 7.00 0.64 7.1% 4.3% BBB+ 17 19 6.6 9.5 8.4 8.4 1.95 2.7 5.80 1.10 12.1% 5.7% BBB 9 9 8.1 11.2 9.1 8.6 1.21 1.6 5.40 1.30 10.0% 4.4% BBB- 12 16 6.1 10.1 8.7 8.6 1.20 2.1 3.00 1.17 10.0% 4.6% BB+ 16 18 0.6 10.7 8.8 9.2 1.04 1.8 5.00 1.00 5.3% 2.7% BB 6 6 8.6 9.5 9.2 9.4 0.72 1.2 2.22 1.80 9.5% 3.4% B+ 1 2 9.6 10.5 10.1 10.1 0.56 1.0 3.33 1.05 5.0% 2.4% B 2 2 13.4 14.6 14.0 14.0 0.56 0.9 5.00 0.80 5.0% 2.8% NR 34 35 0.8 18.7 9.7 9.4 0.90 1.3 5.67 1.06 6.8% 3.3% Portions Adapted from Exhibits 24-5 and 24-6 in “Valuing a Business,” 4th Edition Source: 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 ratios.

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 Debt-to-equity ratio Total debt Total equity Return on equity Earnings before interest and taxes Total equity Pretax return on total capitalization Earnings before interest and taxes Total debt + total equity

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.

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.

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 shows a model of how to summarize those factors.

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

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 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 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 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.