How to Calculate a Required Return of a Preferred Stock

How to Calculate a Required Return of a Preferred Stock

How to Calculate a Required Return of a Preferred Stock

When calculating potential financial investments, it is necessary to prepare for a loss or a profit in most circumstances. The fluctuating market can quickly impact stock values and company investments, so keeping track of your shares will only help your instincts with buying and selling.

What Is a Preferred Stock?

A preferred stock has value similar to both a stock and a bond, making it different from a common stock. A preferred stock has a fixed dividend based on its par value, rather than a dividend that changes with the market. This fixed dividend rate may negatively impact a preferred shareholder’s profits during a time of high market inflation, but each investor prefers different elements of risk.

In the case of bankruptcy, preferred stock is paid out prior to common stock. However, preferred stock rarely has the voting rights of common stock, and while voting rights don’t impact the normal consumer as much as one with a large portion of shares in a company, they still impact the overall value of this type of stock.

The Required Rate of Return

Generally, the required rate of return refers to how much profit a company must have in order to pursue and complete a project or investment. This amount can include a variety of components, from machinery costs to the cost of a merger. The required rate of return also includes risk and the health of the market as a whole in its calculation.

The Formula

A general approach for calculating this amount is dividing an investor’s dividend amount by the stock value. However, preferred stock is a bit different. With preferred stock, you will need to account for its fixed dividend by using the dividend discount approach for calculating a required rate of return. This formula is as follows: k=(D/S)+g.

In order to calculate “k,” which indicates the required rate of return, you will need to collect the following information: "D" (the total dividend amount to be paid out the following year), "S" (the immediate stock value as of that day) and "g" (the dividend’s growth according to its fixed rate).

Make sure that you divide the total dividend amount by the immediate stock value before adding the dividend’s growth to the total. The element of risk may impact this amount according to the stock’s value as it is calculated, so be sure to regularly review stock prices before making any calculations.

Tips

  • Compare the market’s required return for a preferred stock with your own required return. If your required return exceeds the market’s, the current price is too high for your investment needs.
  • Compare required returns among preferred stocks and among different investments to see which ones the market perceives as having higher risk.

Warning

  • A preferred stock’s required return and the actual return you would earn from it might differ. Although preferred dividends are typically fixed, a company can choose not to pay them, which would reduce your actual return.

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About the Author

Heidi Nickerson graduated from Liberty University in 2013 with a Bachelor of Arts in English. She has previous work experience in Financial Aid as a Grants Processor, where she was responsible for reviewing students' FAFSA information against their tax documentation. Prior to that, she worked with an Enrolled Agent to help families and small businesses submit their annual Federal tax returns.