The dividend discount model is also used to measure the value of preference equity in addition to forecasting the value of ordinary equity.

There are certain assumptions and clarifications that need to be made regarding the use of dividend discount model for valuing preference equity.

The purpose of this article is to provide this information in an easy to understand manner.

Preference Shares: Recap

Just to remind the readers, preference shares are securities which can be thought of as being mid-way between debt and equity. Preference shareholders do not get a variable return.

Rather they get a fixed rate of return like debt holders. Thus it does not face the risks of an equity shareholder and also does not get the slow return of a bond holder. It is somewhere in between these two extremes.

This is because payments to preference shares are not legally mandatory. If the company makes a profit, they must receive their fixed dividend before the ordinary shareholders are paid.

Implications:

These defining characteristics of preference shares lead to certain implications. They are as follows:

• Dividends, in case of preference shareholders are fixed. Hence, there need not be any speculation as to what the pattern of dividend payouts will.

  Whether, it will be constant as in the case of the dividend discount model or whether they will grow at a constant rate like in Gordon growth model. The cash flow timings and amounts are almost certain in case of preference shares

• The only risk factors that need to be considered are whether the firm has an option to call the preference shares back and extinguish them.

  Also, if the firm does not make a profit in any given year, then the preference shareholders will not get paid.

Valuation of a Preference Share:

The valuation of preference shares is a very straightforward exercise. Usually preference shares pay a constant dividend. This dividend is the percentage of the face value of the share. For instance, a preference share with the face value of $100 which pays 5% dividend will pay $5 in dividends.

Hence, if the required rate of return of an investor is 10%, then the value of the preference share can be arrived at using the simple formula

Value (Preference Share) = D/r

Where,

D is the constant dollar amount of dividends being received

And r is the required rate of return for the investor

Hence, the value of this preference share would be $5/0.1 = $50

Assumptions:

The risks that the firm can call the bonds back or the profits may not be paid as preferred dividends in a certain year have not been considered in this formula. Hence, if any of these risks is foreseeable, the value derived from the formula i.e. $50 in this case, needs to be reduced to account for that risk.

• The value of the call option can be derived from option pricing models like binomial model, black schools model etc. The value of the preferred share should be adjusted since the buyer of the preferred share is also acting as seller of the call option to the company
• Also, if the analyst forecasts, that some dividends may not be paid out in the future, then they must subtract the present value of the missed dividend from the present value of the preference share.

Conclusion:

A plain vanilla preference share can be easily valued using the dividend discount model. A plain vanilla preferred share is nothing but perpetuity! For more exotic and complex types of preference shares, the initial value is derived from the model and then adjustments are made to account for the risks that have been missed out.