How to Calculate a Required Return of a Preferred Stock

Like investing in any other financial securities, bonds or equity, the required return of a preferred stock changes over time as the risk of the preferred stock perceived by investors becomes higher or lower. To calculate the required return of a preferred stock, investors compare the amount of dividend received to the price of the preferred stock as traded at the time. The dividend amount is set when the stock is issued and will not be changed in the future. Therefore, as the stock price goes up or down, the required return decreases or increases.

Based on the risk assessment of its preferred stock, the issuer decides on the amount of dividend that it believes is comparable to the level of risk that investors are subject to. For example, to compensate shareholders for the higher risk of preferred stock than that of the issuer's debt, the rate of preferred dividend is often set larger than interest rate on borrowing. Preferred dividend is stated either as a percentage of the par value of the preferred stock or a dollar amount per share.

The cost of a preferred stock to the issuer is also the initial required return of the preferred stock by investors at the time of the stock issuance, calculated as the amount of dividend divided by the stock's issuing price. When a preferred stock is issued at par, the cost of preferred stock is effectively the rate of the preferred dividend. Assume a preferred stock pays $12 in dividend and the issuing price is $100 per share. The cost of the preferred stock would be $12/$100 = 12 percent. The current required return can be compared to the initial cost or dividend rate to see how the preferred stock has performed over time.

To calculate required return of a preferred stock, the price of the preferred stock must be a known component in addition to the dividend amount. Though not as volatile as prices of common stocks, the price of a preferred stock can change over time, higher or lower than its initial issuing price. Price movement of a preferred stock indicates that investors' view on the risk of the stock has changed and they are willing to pay more or less for the stock.

Required return of a preferred stock is also referred to as dividend yield, sometimes in comparison to the fixed dividend rate. Suppose the price of the preferred stock with a dividend rate of 12 percent and originally issued at $100 is now traded at $110 per share. The current required return of the preferred stock would then be $12/$110 = 10.91 percent. As the stock price goes up, the required return has come down, suggesting that investors don't see the risk of the stock as high as it was before and are willing to pay more for a safer investment.