Valuation of stock is a critical factor in every business organization. Maximizing the value of an organization’s common stock should be the main objective held by the financial managers. Stock valuation entails valuation of both preferred and common stock (Keown, Martin and Petty 251).
Preferred stock bears the similar characteristics to common stock. The one characteristic of preferred stock is that it has no specific maturity period. Organizations put aside a portion of sinking fund which is used in acquisition of preferred stock in open market (Keown, Martin and Petty 251).
Preferred stock can be issued in a multiple series bearing different characteristics while some may be transformed to common stock and others lack such abilities. The preferred stock has the second right to claim assets before the holders of common stock in case of bankruptcy. They have also priority in claiming income after the debt holders have been paid. Their dividends are paid before common stock bearers. The holders of preferred stock also have a right to claim cumulative dividends before payment of dividends to common stock bearers. The preferred stock holders are also given protective rights which give them voting rights when their financial obligations fail to be met. The preferred stock also bears convertibility rights at the discretion of the holder. Finally, they have a retirement provision where they may be repurchased by the firm after a give time period (Keown, Martin and Petty 252).
Valuation of Preferred Stock
A distinct formula is used to estimate the value of the preferred stock.
Value of preferred stock = Annual Dividend/ Required Rate of Return
Vps = D/ rps
Vps = D1/ (1 + rps)1 + D2/ (1 + rps)2 + … D∞/ (1 + rps) ∞
Vps = value of preferred stock
D = dividends
rps = preferred stock required rate of return
As indicated Keown, Martin and Petty (253) in the above formula for preferred stock signifies that its value is derived from the present value of total expected future dividends which are perpetual in nature. Where the dividends for every year are constant and there is no maturity for the security, the following formula is used to estimate the underlying value of preferred stock;
Vps = D/ rps
Common stock symbolizes ownership of a firm and is usually in form of a certificate. Whilst bond and preferred stockholders are observed as debtors to the organization, common stock bearers are the real owners of the enterprise. The common stock lacks maturity period but is dependent on the life of the enterprise (Keown, Martin and Petty 257).
Characteristics of Common Stock
The right of common stockholders to claim residual income comes after preferred stockholders and debt holders have been paid. They may then claim residue income as dividends or the amount be reinvested in the business. In case of bankruptcy, the common stockholders have also a residual claim of the firm’s assets. Their claim is valid after the debt holders and the preferred stockholders’ claims on assets have been satisfied. The common stockholders have got limited liability in the investment. In case of bankruptcy, the holders of common stock liability are only in proportion to the amount of their investments in the firm. The holders of common stock also hold the ultimate voting rights in the corporation. Common stockholders bear the right to elect the board of directors and also to deliberate and make specific changes in the management structure of the firm. Another characteristic of holders of common stock is the ability to enjoy preemptive rights. These are the rights that ensure each of them hold a substantial proportion of share ownership in the firm (Keown, Martin and Petty 258).