preferred stock valuation

CFA Level I Equities
#1

Ok it’s me again

… I do understand the below problem and solution (taken from the CFAI topic test) except for one thing…

"A company has issued non-callable, non-convertible preferred stock with the following features:

· Par value per share: $10

· Annual dividend per share: $2

· Maturity: 15 years

An investor’s required rate of return is 8%, and the current market price per share of the preferred stock is $25. By comparing the estimated intrinsic value with the market price of the preferred stock, the most likely conclusion is that the preferred stock is:

fairly valued at $25.00. undervalued by $15.00.

overvalued by $4.73.

Incorrect.

Using a financial calculator to find the present value (PV) of the future cash flows, intrinsic value is thus: FV = $10; n = 15; PMT = $2; r = 8%. Compute PV = $20.27.

The preferred stock is overvalued by $4.73 (Market price of $25 – Estimated value of $20.27)."

…

I did 2/0.08 (dividend/required rate)=25.00 USD and my answer was, as you guess, false.

Why can I not apply this formula for this problem?

Thanks!

#2

It says that the preferred stock matures in 15 years, so it’s not a perpetuity.

I’m not familiar with stock (preferred or common) having a maturity; it sounds more like a bond.

1 Like
#3

I made similar mistake with this problem until S2000magician identify the Not a Perpetuity clause. I think that is the key to the question.

Thanks S2000magician and Swissfox for this.

#4

My pleasure.