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Principles of Finance Videos 166 videos

Principles of Finance: Unit 1, Company Formation, Structure, Inception
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Principles of Finance: Unit 6, Valuing a Preferred Stock 5 Views


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Valuing a preferred stock…à la Shmoop.

Language:
English Language

Transcript

00:00

Principles of finance ah la shmoop valuing a preferred stock

00:07

somewhere somehow sometime ago maybe even in a galaxy far

00:11

far away some finance geek came out with the notion

00:15

of a required rate of return So wait what is

00:19

required here and what used items are you now returning

00:23

While a required rate of return is the minimum amount

00:26

that you expect to get back on a given investment

00:29

all else held equal That is if there are lots

00:32

of safe things out there where you know with great

00:35

certainty you'll get five percent a year return And then

00:38

along comes something a riskier like a stock in a

00:42

company that makes heavy winter coats for polar bears Then

00:45

you might have to expect a return of twenty thirty

00:48

forty one hundred percent or more in order for the

00:50

activity or investment to be worth casting the line in

00:54

the water and taking them or risk than that five

00:56

percent certainty thing So the yachts who came up with

00:59

a required rate of return applied it to well well

01:02

pretty much everything notionally or set in a different way

01:05

A required rate relates to the risk premium that has

01:09

to be paid above the risk free rate in order

01:11

for an investment to be worth doing all right now

01:14

let's Map this notion onto the valuation process of a

01:17

preferred stock which usually looks a lot like a bond

01:20

that's convertible into common stock and pretty vanilla In practice

01:23

let's say you have a very safe preferred stock backed

01:26

by a well funded defense company The u s government

01:29

needs this company to be healthy in the thousand dollars

01:32

par preferred pays five percent interest You think it's about

01:35

a safe is a t bill which pays two percent

01:38

interest Well what is that preferred worth to you We'll

01:41

get the answer You just take the dividend divided by

01:44

the required rate of return In this case we'd have

01:47

a thousand dollars times at five percent All divided by

01:50

that two percent see thousand times the point o five

01:52

dried by pointing to its fifty bucks divided by that

01:55

point too Which gives you twenty five hundred that's an

01:58

interesting number So you think that prefered yielding five percent

02:01

is a huge bargain it's worth two and a half

02:04

times that very safe government paper huh Interesting And if

02:08

you look at that two percent and in the five

02:10

percent there yeah that's two and a half times that

02:12

number Why Well it's paying you five percent interest and

02:16

to you from a risk perspective it feels identical that

02:20

the two percent government paper for a thousand bucks you're

02:23

able to buy a dividend stream for which other idiots

02:26

are paying twenty five hundred Well this comparison works in

02:29

other directions to and it's not tax adjusted and it's

02:32

also not adjusted for the fact that preferred stocks don't

02:34

necessarily ever end They can kind of keep going and

02:37

whips all you around so the securities are not identical

02:40

but just go with us here on the concept for

02:42

a moment there's a five thousand dollar part preferred stock

02:45

backed by the bank of confederate currency it yield seven

02:48

percent But you think it's highly likely tio have problems

02:52

The south did not in fact rise again So you're

02:56

required rate is more like twelve percent there and your

02:59

gut tells you it should be more like forty or

03:01

for hundred percent or maybe a whole lot more because

03:04

in the south ain't rising again because the odds of

03:06

this company going bankrupt in three or four years Well

03:09

they're pretty good at forty percent return You get one

03:11

hundred twenty percent of your investment back in three years

03:14

I all your money back plus down six percent and

03:16

change a year which wouldn't be a terrible investment on

03:19

its own But doing the math on a twelve percent

03:21

hurdle you calculate that your five thousand dollar investment yielding

03:25

seven percent should really be yielding a whole lot more

03:28

to warrant all this risk That is five thousand dollars

03:31

par preferred yielding seven percent distributes three hundred fifty bucks

03:35

a year seven percent times at five thousand You believe

03:38

that in order for this investment to be worthwhile or

03:40

worth doing you need to have the dividends in three

03:43

years pay for the entire investment and then some and

03:46

maybe a lot more so very very risky So after

03:49

three years this preferred would have to have paid three

03:51

times three and fifty dollars or a thousand fifty And

03:54

even though it has par value of five thousand the

03:57

price that you would pay to get risk parity here

04:00

would only be a grander so even though others are

04:02

a lot more bullish on the confederacy returning and its

04:05

currency becoming the dominant faction again in the united states

04:09

And this applies everywhere even in alabama So think about

04:12

that when you value a preferred stock or a stream

04:15

of dividends Coming off of a preferred against all the

04:18

other investment opportunities you could make like very safety bills 00:04:22.373 --> [endTime] or very risky equities or anything in between

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