In this article, I will show you how to calculate and interpret the cost of preferred stock for a company. Preferred stock serves as a hybrid financing option for companies, combining features of both debt and equity. As a hybrid security, it offers regular dividends and holds a higher priority than common stock, yet ranks below bonds in the claims hierarchy.

Understanding the cost of preferred stock is important for assessing funding options and potential returns. It factors into the company's Weighted Average Cost of Capital (WACC), affecting the overall cost of capital. Although preferred stock usually has minimal impact on firm valuation, except in rare cases, its inclusion in valuation assessments is recommended for accuracy.

This article explains preferred stock, how it compares to debt and common stock equity financing, and its three different types. It then details the cost of preferred stock formula and demonstrates this calculation with a real-world example.

Cost of Preferred Stock Explained

The cost of preferred stock represents the return a company must provide to its preferred shareholders, reflecting the dividends it commits to paying and serving as a key component of the firm's cost of capital.

This type of stock occupies a unique position in a company's capital structure, offering a blend of equity's potential for appreciation with debt-like features such as fixed dividends and a par value, but without the voting rights common to equity shares. Dividends for preferred stock are considered a guaranteed return, prioritized over common stock dividends and accumulating if unpaid, emphasizing the preferential treatment in both dividends and liquidation, albeit ranking below bondholders for asset claims.

From a tax perspective, preferred stock dividends are paid from after-tax earnings, unlike the tax-deductible interest expenses of debt, making its cost higher due to this non-deductibility. However, the cost of preferred stock typically remains below that of common stock since investors generally demand higher returns for the latter. This tax treatment and the comparative cost implications highlight the strategic role of preferred stock in corporate finance and capital raising decisions.

Preferred Stock vs. Common Stock and Bonds (Debt)

As a hybrid asset, understanding how preferred stock contrasts with both common stock and debt, typically in the form of bonds, is important.

Preferred Stock vs. Common Stock

Below is a comparative overview of preferred stock vs. common stock:

Preferred Stock vs. Bonds (Debt)

Below is a comparative overview of preferred stock vs. bonds (debt):

Three Types of Preferred Stock

Understanding the different types of preferred stock is useful for investors calculating its cost, as these variations significantly influence the perceived risk and return profile of the investment. Although the formula and its output for calculating the cost of preferred stock remain consistent, specific characteristics such as cumulative, convertible, or redeemable features can affect investors' perceptions of risk and return associated with the stock.

Each type of preferred stock comes with distinct features that can influence dividend payments, conversion rights, and redemption policies, as described below.

Cumulative Preferred Stock

Cumulative preferred stock allows companies to suspend dividend payments during financial hardships, with the obligation to pay these dividends later before any dividends can be paid to common stockholders. This feature ensures that dividends accumulate if not paid, safeguarding investors’ rights to receive missed payments in full before any distribution to common shareholders. Investors are given priority over common stock in terms of dividend payments, making it a safer option during economic downturns.

The accumulation feature of cumulative preferred stock ensures that the calculation of its cost must consider the eventual payment of all accrued dividends. This might lead to a higher present value of expected dividends, especially in scenarios where dividends are suspended. For example, if a company suspends dividends for two years but is obligated to pay all accumulated dividends in the third year, the cost of preferred stock calculation would reflect the total dividend payments due, ensuring investors are compensated for the delay.

Convertible Preferred Stock

Convertible preferred stock can be exchanged for a predetermined number of common shares, often at the discretion of the investor, based on specific conditions or a predetermined conversion date. The conversion is usually most beneficial if the common stock’s price exceeds the preferred stock’s net present value, offering potential for capital appreciation. This type provides flexibility, allowing the company to potentially reduce dividend payments and offering investors a chance to benefit from the company's growth.

The convertible feature introduces a potential for capital gains into the cost of preferred stock calculation, in addition to the dividend yield. This can make the preferred stock more attractive and potentially lower the required dividend yield to entice investors. For instance, if an investor can convert their preferred shares into common shares, which they anticipate will increase in value, they might accept a lower dividend yield on the preferred stock, affecting its cost calculation.

Redeemable Preferred Stock

Redeemable preferred stock gives companies the right to repurchase the stock at a predetermined price after a specified date, often used to manage capital costs more effectively. To compensate for the redemption risk, these shares typically offer higher dividend rates to investors, making them an attractive option despite the potential for early redemption. This feature is particularly relevant in scenarios where interest rates drop, allowing companies to redeem high-cost preferred stock and possibly reissue at a lower rate, affecting investor returns.

The redeemable nature of this preferred stock type usually results in a higher dividend rate to compensate for the risk of redemption, directly influencing its cost calculation. The higher dividend requirement can increase the cost of capital for the company but also indicates a higher yield for investors. For example, a redeemable preferred stock with a 6% dividend rate in a market where similar non-redeemable shares offer 5% would reflect the additional risk premium investors require, thereby increasing the calculated cost of preferred stock for the company.

How to Identify Preferred Stock in a Company

Most companies do not have outstanding preferred stock. In fact, within the S&P 500, only a small fraction of companies issue preferred shares as part of their capital structure. This figure can vary, but it is generally well below ~20%. If a firm has not issued preferred stock, its cost is considered non-applicable in the context of capital structure analysis. Attention then shifts to other components like equity and debt when calculating the Weighted Average Cost of Capital (WACC).

The most straightforward way to determine if a company has issued preferred stock is by examining the company's annual (10-K) and quarterly (10-Q) reports. These documents are accessible on the company's website under the "Investor Relations" section or through the SEC's EDGAR database.

Searching these documents for "preferred stock" is a practical approach, and the balance sheet along with the notes to the financial statements are especially insightful for identifying the presence of outstanding preferred stock:

• Balance Sheet: The balance sheet provides a snapshot of a company's financial condition at a specific point in time. Check the equity section of the balance sheet. If the company has issued preferred stock, it will be listed separately from common stock, alongside the par value of the preferred stock and possibly the number of shares issued.
• Notes to Financial Statements: These notes offer an in-depth explanation of the financial statements' figures, including details on preferred stock such as the dividend rate, redemption rights, conversion rights, and any special voting rights. These notes can offer a comprehensive view of the preferred stock's features and conditions.

Now, if the company's fiscal reports lack information, especially the market price for preferred stock, which changes regularly, consulting reliable online financial data sources is advisable. These resources often provide detailed data on a company's issued preferred stock(s).

Here are three recommended sites for preferred stock information:

• Company's Investor Relations: Directly accessing a company's investor relations page is recommended for obtaining the most accurate, official, and up-to-date information about its preferred stock. These pages often includes press releases, financial reports, and dividend announcements, providing investors with details straight from the source.
• Yahoo Finance: Known for its comprehensive financial news, data, and commentary, including real-time stock quotes and historical data. This makes it a reliable source for tracking the performance and dividend information of preferred stocks.
• Preferred Stock Channel: Specializes in preferred stock data, offering detailed insights into dividend yields, series specifications, and market prices. This makes it invaluable for investors focused on preferred securities.

In short, if a company doesn't explicitly state that it has preferred stock outstanding in its most recent 10-K annual statement, and if you cannot find preferred stock information from the sources provided above, then it's likely that the company does not have any preferred stock to be considered in its cost of preferred stock calculation.

Cost of Preferred Stock Formula

The cost of preferred stock formula calculates the expected return from investing in preferred stock, taking into account the annual dividends, the current market price of the stock, and, when applicable, the perpetual dividend growth rate.

The cost of preferred stock formula is shown below:

R_p = (D_p / P_p) + g

where:

• R_p = cost of preferred stock
• D_p = dividends per preferred share
• P_p = current price per preferred share
• g = perpetual dividend growth rate

The formula for the cost of preferred stock resembles the perpetuity formula due to its unamortized nature. Preferred stock, similar to a perpetuity, is considered to last indefinitely with fixed dividend payments continuing forever. This likeness allows us to apply similar principles used in perpetuity valuation to determine the cost associated with preferred stock.

In perpetuity valuation, a perpetuity is a financial instrument that pays a fixed amount regularly, theoretically continuing indefinitely. This is used to value assets like bonds or preferred stock, where the cash flows are assumed to persist perpetually. The perpetuity formula calculates the present value of these future cash flows, considering the time value of money and the risk associated with the investment.

When applied to preferred stock, the cost calculation involves projecting the growth in the preferred stock's dividend per preferred share (D_p) for one year. This is then divided by the price of the preferred stock (P_p). Additionally, the anticipated perpetual growth rate (g) is added to this calculation. By doing so, we determine the cost of capital associated with preferred stock, considering both the inherent risk and the opportunity cost of capital.

Cost of Preferred Stock Example

We'll use AT&T (T) for our cost of preferred stock example. AT&T is a leading global telecommunications, media, and technology company known for its wide range of services including mobile and fixed telephone services, broadband subscription, and digital entertainment.

Upon reviewing AT&T's latest 10-K annual report for FY 2023, specifically within the stockholders' equity section of the company's balance sheet, we observe line items for preferred stock. It reveals that, out of 10,000,000 authorized shares, 138,000 shares are issued and outstanding, as outlined below:

For the purpose of calculating the cost of preferred stock, investors should concentrate on the issued and outstanding preferred stock, as it represents the shares that have been issued and are currently held by investors, directly affecting the company's cost of capital.

Now, to find the numerator of the cost of preferred stock formula (dividends per preferred shared ((D_p)), we need one of the following:

1. Dividend Rate per Share: This is usually expressed as a percentage. If you know the dividend rate, you can calculate the annual dividend per share by applying this rate to the par value of the preferred stock or to the dividend amount directly stated per share.
2. Total Annual Dividend: In some cases, you might have the total annual dividend amount paid on all preferred stock. You can divide this by the total number of outstanding preferred shares to get the annual dividend per share.

Given this, the "Notes to Financial Statements" section in the same 10-K annual report for AT&T provides further detail that can be used to calculate the company's dividends per preferred share (D_p) for each series stage:

With this information, the dividends per preferred share (D_p) for each series stage of AT&T's preferred stock are calculated based on the liquidation preference and the dividend rate for each series:

• Series A: With a liquidation preference of $25,000 per share and a dividend rate of 5.000%, the annual dividend per share is $1,250 ($25,000 * 5.000%).
• Series B: With a liquidation preference of €100,000 per share and an initial dividend rate of 2.875%, the annual dividend per share is €2,875 (€100,000 * 2.875%).
• Series C: With a liquidation preference of $25,000 per share and a dividend rate of 4.75%, the annual dividend per share is $1,187.50 ($25,000 * 4.75%).

For reference, AT&T's Investor Relations pages for its Series A, Series B, and Series C preferred stocks also display the same per-share numbers, but these are listed on a quarterly basis (except for Series B, which is annual), aligning with the frequency of their preferred dividend payments.

Notably, the Series B stock is denominated in Euros rather than USD, has the fewest shares outstanding, and lacks information on its market price. Therefore, we'll exclude it from our cost of preferred stock calculation for AT&T in this example.

These preferred stock pages for AT&T also have a column for "Per Depositary Share," indicating that investors buy shares in a trust that holds preferred shares. Per depositary share refers to a fraction of ownership in a trust that represents one or more underlying preferred shares. Using the per depositary share numbers, which are $1.25 and $1.1875 respectively for the company's Series A and Series C shares, is therefore more accurate for calculating the cost of preferred stock. This approach ensures the calculation is relevant to individual investors who buy and sell depositary shares rather than the full preferred shares, which have a much higher value and dividend amount.

Now, we can find the market price per preferred share (P_p) for the Series A and Series C preferred stocks. These market prices can be found on stock exchanges and financial information platforms, such as Yahoo Finance and Preferred Stock Channel (as described prior), where these securities are typically listed. Below are the market prices for both of these series stages at the time of writing this article:

• Series A Market Price (P_p): $21.63
• Series C Market Price (P_p): $20.61

For reference, the live stock chart for these preferred stocks are displayed below (each on its own price scale):

Given these figures, and assuming there's no perpetual dividend growth rate (g) component for either series stages, since nothing was explicitly stated in the company's most recent 10-K annual report, we can calculate the cost of preferred stock (R_p) for both series stages:

R_p Series A [T] = $1.25 / $21.63 --> 0.0578 or 5.78%

R_p Series C [T] = $1.1875 / $20.63 --> 0.0576 or 5.76%

These percentages represent the annual return investors would require for investing in Series A and Series C preferred stocks of the company at the current market prices. For AT&T, these rates are also useful for comparing the costs of different financing options. Issued preferred stock with a 5.78% or 5.76% cost may be more or less attractive than other forms of financing, depending on current market conditions and the company's specific financial situation.

How to Calculate the Weighted Average Cost of Preferred Stock

When calculating the Weighted Average Cost of Capital (WACC) and considering the cost of preferred stock for a company like AT&T with multiple series of preferred stocks, it's typical to take a weighted average of the costs of each series of preferred stock based on their respective market values.

For this example, we'll only consider Series A and Series C preferred stocks since Series B is excluded due to a lack of market price information.

The steps below describe how to perform this calculation.

Step #1: Calculate the Market Value of Each Series of Preferred Stock

Begin by determining the total value of each series of preferred stock by multiplying the number of shares by the market price per share.

Market Value (Series A Preferred Stock = 48,000 shares × $21.63 per share = $1,038,240

Market Value Series C Preferred Stock = 70,000 shares × $20.61 per share = $1,442,700

Step #2: Calculate the Total Market Value of Preferred Stocks

Next, add up the market values of all series of preferred stocks to find the total market value.

Total Market Value = $1,038,240 + $1,442,700 = $2,480,940

Step #3: Calculate the Weight of Each Series of Preferred Stock

Then, divide the market value of each series of preferred stock by the total market value to determine its proportion or weight.

Weight of Series A Preferred Stock = $1,038,240 / $2,480,940 ≈ 0.4186 (or 41.86%)

Weight of Series C Preferred Stock = $1,442,700 / $2,480,940 ≈ 0.5814 (or 58.14%)

Step #4: Calculate the Weighted Average Cost of Preferred Stock

Finally, multiply the weight of each series of preferred stock by its respective cost of capital, then sum the results to find the weighted average cost of preferred stock.

Weighted Average Cost of Preferred Stock = (41.86% × 5.78%) + (58.14% × 5.76%) --> 0.0577 or 5.77%

Thus, the weighted average cost of preferred stock for AT&T, considering only Series A and Series C preferred stocks, is ~5.77%.

The Bottom Line

Preferred stock serves as a hybrid financing tool, combining the fixed-income feature of debt with the equity aspect of common stock financing, without granting voting rights to its holders. It offers fixed dividends and ranks above common stock in the event of liquidation, but below bonds, ensuring a specific level of security for investors. Despite its limited issuance and impact on the cost of capital, neglecting preferred stock can lead to inaccurate assessments of the cost of capital.

There are three types of preferred stock, each affecting the perceived risk and return profile of the investment: cumulative preferred stock, which accumulates unpaid dividends; convertible preferred stock, which offers the potential for conversion into common shares; and redeemable preferred stock, which can be bought back by the issuer.

The cost of preferred stock formula calculates the expected return from investing in preferred stock. It takes into account the annual dividends, the current market price of the stock, and, when applicable, the perpetual dividend growth rate. This calculation contributes to a nuanced understanding of the company's Weighted Average Cost of Capital (WACC), which is commonly used to evaluate investment opportunities and determine the cost of capital from a company's various sources of financing.

In conclusion, understanding the role and impact of preferred stock is essential for accurate financial analysis and informed investment decisions.