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Principles of finance ah la shmoop valuing a preferred stock

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somewhere somehow sometime ago maybe even in a galaxy far

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far away some finance geek came out with the notion

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of a required rate of return So wait what is

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required here and what used items are you now returning

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While a required rate of return is the minimum amount

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that you expect to get back on a given investment

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all else held equal That is if there are lots

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of safe things out there where you know with great

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

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along comes something a riskier like a stock in a

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company that makes heavy winter coats for polar bears Then

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you might have to expect a return of twenty thirty

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forty one hundred percent or more in order for the

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activity or investment to be worth casting the line in

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the water and taking them or risk than that five

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percent certainty thing So the yachts who came up with

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a required rate of return applied it to well well

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pretty much everything notionally or set in a different way

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A required rate relates to the risk premium that has

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to be paid above the risk free rate in order

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for an investment to be worth doing all right now

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

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preferred stock which usually looks a lot like a bond

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

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

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by a well funded defense company The u s government

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needs this company to be healthy in the thousand dollars

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

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a safe is a t bill which pays two percent

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

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get the answer You just take the dividend divided by

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

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a thousand dollars times at five percent All divided by

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that two percent see thousand times the point o five

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dried by pointing to its fifty bucks divided by that

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

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interesting number So you think that prefered yielding five percent

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

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times that very safe government paper huh Interesting And if

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you look at that two percent and in the five

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

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

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to you from a risk perspective it feels identical that

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

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able to buy a dividend stream for which other idiots

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are paying twenty five hundred Well this comparison works in

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

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

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necessarily ever end They can kind of keep going and

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whips all you around so the securities are not identical

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but just go with us here on the concept for

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

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backed by the bank of confederate currency it yield seven

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

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

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required rate is more like twelve percent there and your

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gut tells you it should be more like forty or

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for hundred percent or maybe a whole lot more because

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

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this company going bankrupt in three or four years Well

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

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hundred twenty percent of your investment back in three years

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I all your money back plus down six percent and

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

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its own But doing the math on a twelve percent

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hurdle you calculate that your five thousand dollar investment yielding

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seven percent should really be yielding a whole lot more

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to warrant all this risk That is five thousand dollars

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par preferred yielding seven percent distributes three hundred fifty bucks

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a year seven percent times at five thousand You believe

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that in order for this investment to be worthwhile or

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worth doing you need to have the dividends in three

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years pay for the entire investment and then some and

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maybe a lot more so very very risky So after

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three years this preferred would have to have paid three

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times three and fifty dollars or a thousand fifty And

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even though it has par value of five thousand the

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price that you would pay to get risk parity here

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would only be a grander so even though others are

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a lot more bullish on the confederacy returning and its

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currency becoming the dominant faction again in the united states

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And this applies everywhere even in alabama So think about

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that when you value a preferred stock or a stream

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of dividends Coming off of a preferred against all the

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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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