Lesson 4 of 7 · 15 min

Preferred stock and the Gordon growth model

A perpetual preferred share is a perpetuity worth D/r, and a common share with dividends growing at a constant rate forever is a growing perpetuity worth D1/(r−g)D_1/(r-g).

In short

  • Non-callable, non-convertible perpetual preferred: V0=D/rV_0 = D/r. With a maturity: price it like a bond, using par value at maturity.
  • A call option (issuer's) lowers a preferred's value to the investor; a retraction (put) option raises it.
  • Gordon growth model: V0=D0(1+g)/(r−g)=D1/(r−g)V_0 = D_0(1+g)/(r-g) = D_1/(r-g). Needs r>gr > g; uses the next dividend.
  • Best for mature, dividend-paying companies that are insensitive to the business cycle and have a stable dividend growth record.
  • Sustainable growth: g=b×ROEg = b \times ROE, where b = 1 − payout ratio.
  • Value is very sensitive to r and g: small input changes move it a lot.

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Preferred stock and the Gordon growth model · Equity Valuation: Concepts and Basic Tools