Of the many ways you or your company can make a long-term investment is through preferred stock, the benefit of which is determined by looking at the cost of preferred stock.
Preferred to stock is viewed as both kinds of equity, as well as a debt instrument. It is equity because it has the potential to appreciate in value over time.
On the other hand, it can be viewed as a debt instrument because it also pays you fixed dividends over time.
We have all heard of the saying, “time is money”. Well, nowhere is this notion truer than in stocks. The key principle behind the value of stock is the time value of money.
Simply put, the cost of preferred stock is the rate of return that is yielded by the specific company's preferred stock for you as a preferred shareholder.
"Preferred" in this case actually means that if you are a shareholder with these stocks, you are given priority over other types of shareholders.
Those holding preferred stocks (also known as preferred shareholders) have to be paid before dividends can be paid to common stock shareholders. This is also true in the event of the company being liquidated.
In cases of dire financial distress, your payments as a preferred shareholder can be done according to what is known as a “cumulative” arrangement.
This just means you are paid in arrears. Preferred stockholders, however, are not superior to bond holders.
How to Calculate Cost of Preferred Stock
In order to calculate the cost of preferred stock, you can use the following formula:
Cost of Preferred Stock = Annual Dividends / Current Market Price
The cost of preferred stock is calculated by dividing the annual dividends on the preferred stock by the current market price of preferred stock.
Company A has preferred shares worth dividends of $5 per year. Each share currently sells for $80.
- Dividends on Preferred Stock = $5
- Current Market Price = $80
You can find the cost of preferred stock by calculating as follows:
Cost of Preferred Stock = $5 / $80 = 6.25%
Thus, company A’s cost of preferred stock is 6.25%.
Company B is currently selling at $75 per share. It yields an annual dividend of $12.
To find the cost of preferred stock in this instance you will calculate as follows:
Cost of Preferred Stock = $12 / $75 = 16%
Thus, company B’s cost of preferred stock is 16%.