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Understanding & Valuing Preference Shares

03 January 2020

Understanding & Valuing Preference Shares

Preference Shares are issued by corporations or companies with the primary aim of generating funds. In general, in case of any exit event, preference shareholders have preferential rights for payment of dividend and the liquidation preference over common shareholders.

Characteristics of Preference Shares

There are three main characteristics which define and drive a preference share Valuation – nature of coupon/dividend, redemption terms and conversion terms.

1. Coupon/Dividend: Coupon can be zero, cumulative or non-cumulative. Additionally, one might see instances involving moratorium in accrual/payment of coupon for a part of the preference share tenure.

2. Redemption: Redemption is the settlement in cash, either at maturity or in an amortizing fashion over multiple redemption dates. Redemption may be defined in terms of a fixed redemption premium, but far more popular option is to define it by an effective IRR requirement, with redemption premium quantum getting adjusted for coupon payments already made prior to redemption.

3. Conversion: Conversion indicates settlement in equity shares of the Issuer. Conversion may be defined in terms of a fixed or formula driven conversion ratio/ price.

Combinations of the above characteristics lead to various types of preference shares. Some of them are discussed below:

· Cumulative: All dividends are carried forward until specified, and paid out only at the end of the specified period.

· Non-cumulative:Dividends are paid out of profits for every year as per terms of the agreement. There are no arrears carried over a time period to be paid at the end of the term.

· Redeemable:A company issues them to shareholders and later redeems them. This means the company can buy back the shares at a later date.

· Non-Redeemable:Such shares cannot be redeemed during the lifetime of the company, but can only be obtained at the time of winding up (liquidation) of assets.

· Convertible:The shares can be converted into equity shares after a time period as per the conditions laid down in the terms.

· Non-convertible:Non-convertible preference shares as per name explains cannot be, at any time, converted into equity shares.

· Participating:Such shares have the right to participate in any additional profits to the extent as per conditions laid down in the terms, after paying the equity shareholders.

· Non-Participating:Non-participating preference shares do not possess any right to participate in any surplus profits at the time of liquidation of the company.

The following Indian Accounting Standards or Ind AS standards apply to them:

Ind AS 32: Presentation and classification of financial instruments

Ind AS 109: Recognition, de-recognition, classification and measurement of financial instruments

Ind AS 113: Principles of fair value measurement that would be applicable to financial instruments

Ind AS 107:Disclosures required with respect to financial instruments.

For Fair Value Measurement (FMV) of preference shares, we rely primarily on the principles discussed in Ind AS 113 and terms of its measurement as indicated in Ind AS 109.

Let’s have a quick look at three classical Valuation Approaches which are typically applied in business valuation and can be extended to financial instruments as well.

1. Income Approach:The discounted cash flow (DCF) analysis is the primary methodology used for Valuation of compulsorily convertible preference shares and the redeemable preferred shares. Two inputs to the DCF model are cash-flows and the discount factor. Cash can flows take any form i.e. dividends, coupon, redemption, or maturity amount, underlying equity shares upon conversion at triggering event or at the end of the term. 

A Valuer must assess the availability of cash-flows, triggering condition and the likelihood of each event which can impact the cash flows available during and/or at the end of the period as indicated in the term sheet of preference shares.

2. Market Approach:Our quick assessment of the listed preference shares market in India indicates that the market lacks the depth. Most of the preference shares are privately placed and full feature disclosure is not available in the public domain. Further, trade information/ frequency in case of listed preference shares is low. This poses a challenge to carrying out any meaningful analysis based on comparable transaction method.  Therefore, market approach is seldom applicable in case of preferred shares valuation.

3. Cost Approach:Ind AS 109 allows recognizing financial asset/ liabilities through the amortized cost method, under specific circumstances, when the concept of SPPI (Solely held to collect principal and interest) is fully satisfied, particularly in case of RPS, which is non-convertible but redeemable at maturity.

Importantly, in most of the cases where preferred shares are deriving its value from the conversion into its underlying equity shares, as first step, it would require business/ equity valuations using the combination of above mentioned three approaches depending on the nature, size and requirement of valuation.

Once the value of the company is determined, next step is to allocate the value among different class of securities like convertible debt, common equity and preferred equity.  Each class of shares/instruments have different rights and preferences like liquidation preference, participation rights, conversion rights, redemption rights, anti- dilution rights, voting rights and many other features attached with the securities.  Some are qualitative in nature and difficult to quantify like voting rights differential, however most of them are quantifiable as economic gain or loss can be ascertained in favorable and/or unfavorable events.

The Option Pricing Method (OPM) is most commonly used for allocation of enterprise value among different security classes. OPM treats securities, including debt, common and preferred stock, as a series of call options on the enterprise’s value, with exercise prices based on the securities’respective liquidation preferences, redemption premium and/or conversion terms. Thus, the common stock is a call option with a claim on the enterprise at an exercise price equal to the remaining value immediately after the liquidation preferences are fulfilled and considering the relevant rights of the preferred stock (e.g., participation) as well as the potential dilution from other outstanding securities such as options and warrants.

Binomial lattice method and Monte Carlo simulation method are the other two methods to value the complex instruments depending on whether the payoffs are linear or non-linear, path dependent or not, and/or risk neutral assumption in OPM method holds true or not.

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