How do you value preferred stock using the perpetuity model, and what drives preferred stock yields?

Preferred stock is a hybrid security — it has features of both equity and fixed income. For CFA Level I, the perpetuity model is the primary valuation approach.

The Perpetuity Model:

Since preferred stock pays a fixed dividend indefinitely (no maturity date):

V_preferred = D_preferred / r

Where D_preferred is the annual preferred dividend and r is the required rate of return.

Example:

Sterling Industries issues preferred stock with a $100 par value paying a 6% annual dividend. Investors require an 8% return.

V = $6.00 / 0.08 = $75.00

The preferred stock trades at a discount ($75 < $100 par) because the coupon rate (6%) is below the market's required return (8%).

What Drives Preferred Stock Prices?

Callable Preferred Stock:

If Sterling's preferred is callable at $102, and market rates drop to 4%:

• Theoretical value: $6 / 0.04 = $150
• But Sterling will call it at $102
• Market price will approach $102, not $150

Callable preferred stock has a price ceiling near the call price, which creates negative convexity — a concept you'll explore more deeply in CFA Level II fixed income.

Adjustable-Rate Preferred Stock (ARPS):

The dividend rate resets periodically (e.g., quarterly) based on a benchmark rate. Because the dividend adjusts to market conditions, ARPS trades closer to par value and has lower price volatility than fixed-rate preferred.

Preferred vs. Common Stock:

• Preferred dividends are fixed and take priority over common dividends
• Preferred holders generally have no voting rights
• In liquidation, preferred claims come before common but after all debt
• Preferred dividends may be cumulative (missed dividends accumulate) or non-cumulative

Exam tip: The CFA Level I exam frequently presents a preferred stock with a par value, stated dividend rate, and required return, then asks for the intrinsic value. Remember: this is simply D/r. Watch for questions that test whether the preferred trades at a premium (coupon rate > required return) or discount (coupon rate < required return).

For more equity valuation practice, check our CFA Level I question bank on AcadiFi.