How To Find Undervalued Preferred Stocks

How To Find Undervalued Preferred Stocks. I present a metric to do just that. The metric can be uniformly used across all stocks making it easier to compare multiple issues.

Written By Canadian Preferreds

On December 15, 2019
"

Read more

In this article I will explain metric “Rate Increase (percent | to value )” and “New Spread (%Increase | value)” used in the compare tools.  These metrics will help you Find Undervalued Preferred Stocks.  As you will see, these are the most important metrics for identifying great value in preferreds, especially when comparing a large set like all insurance companies.

Rate Increase (percent | to value ) is the first metric I will explain. To help understand the metric, we break it down to its most basic components, and then build it up to the level where it provides usable meaning.  All calculations in the make up of the metric are presented here, and as a result, making it easier to verify and understand.

Process to Find Undervalued Preferred Stocks.

Let us consider “Enbridge Series 17, Cumulative Redeemable Preference Shares”. Ticker ENB-B.
This was issued back on OCTOBER 28, 2010 at $25.  The terms state “The Annual Fixed Dividend Rate for the ensuing Subsequent Fixed Rate Period …. will be equal to the sum of the Government of Canada Yield (as defined herein) on the Fixed Rate Calculation Date plus a spread of 2.40%.  This spread will remain unchanged over the life of the Series B Shares.”

Metric Components

For this and all resets, 3 components make up the valuation process:

  1. The purchase price.
  2. The “BASE RATE”.  In this case the 5 Year Government of Canada Yield. (GOC Yield).
  3. The “SPREAD“.  In this case 2.4%. We call this “ISSUE: SPREAD”.

Example setup

For example, let’s assume BuyerA purchases the stock at issue.  For this buyer, 2 of the components remain fixed.  As long as BuyerA holds ENB-B the spread will be 2.4% and the cost (purchase price) will be $25.

Now assume BuyerB purchases ENB-B today (2019Dec28).  For this buyer, the same two components remain fixed.  As long as BuyerB holds ENB-B the yield will be 5.80% till the next reset and the cost (purchase price) will be $14.72. Here is the important point. What is the current and reset yields BuyerB is getting? What is the Rate Increase for BuyerB? How did we arrive to this value? This is what we calculate with this metric.

metric formula and calculations

The current dividend is $0.85 reflecting a yield of 5.80%.  The yield structure is made up of the “BASE RATE” plus the “ISSUE:SPREAD”. 

The “BASE RATE” is today’s 5 Year GOC Yield. To calculate the spread we need to calculate today’s yield based on the “CURRENT PRICE” of the stock and the “BASE RATE”. 

Firstly, we determine what the “NEW YIELD” is, based on today’s “CURRENT PRICE” and “BASE RATE”. This is done in two steps: 

a) Get the new dividend. ($1.007) 

The calculation is: “NEW DIVIDEND” = FACE VALUE * (BASE RATE + ISSUE:SPREAD)  

Face Value Base Rate, 5YR GOC ISSUE: SPREAD Dividend New Yield @ Reset BuyerA
 $    25.00 1.627% 2.400%  $    1.007 4.027%

The new yield for BuyerA is 4.027% due to the purchase price of $25.

Secondly, calculate the RATE INCREASE TO VALUE (6.85%)

 Get the “NEW YIELD” (6.85%) for BuyerB

The calcuation is:  “NEW YIELD” = “NEW DIVIDEND” / “CURRENT PRICE” 

CURRENT PRICE NEW YIELD BuyerB
 $                 14.56 6.85%


 

Thirdly, calculate the “RATE INCREASE PERCENT” (69%) .

The calculation is “RATE INCREASE PERCENT” = (NEW YIELD BuyerB – New Yield @ Reset BuyerA) / New Yield @ Reset BuyerA

 NEW YIELD BuyerB  New Yield @ Reset BuyerA  New Yield @ Reset BuyerA  RATE INCREASE PERCENT
6.839% 4.027% 4.027% 69.84%

 

This completes the calculation. We now have arrived at the two parts of the metric. By sorting any of our compares tools on this metric you will be presented with the preferred offering the highest value. It’s a great and easy way to get the information with very little work.

Potential Future Returns For Each Buyer

In the table below we projected potential future yields for both buyers based on various “5Year GOC RATE” values.

Buyer A Buyer B
Face Value 5YrRate Spread Dividend New Yield @ Reset   Market Price New Current Yield Yield increase Yield % Increase
 $    25.00 0.500% 2.400%  $    0.725 2.900%    $    14.75 4.915% 2.015% 69.492%
 $    25.00 1.000% 2.400%  $    0.850 3.400%    $    14.75 5.763% 2.363% 69.492%
 $    25.00 1.500% 2.400%  $    0.975 3.900%    $    14.75 6.610% 2.710% 69.492%
 $    25.00 2.000% 2.400%  $    1.100 4.400%    $    14.75 7.458% 3.058% 69.492%
 $    25.00 2.500% 2.400%  $    1.225 4.900%    $    14.75 8.305% 3.405% 69.492%
 $    25.00 3.000% 2.400%  $    1.350 5.400%    $    14.75 9.153% 3.753% 69.492%

Find Undervalued Preferred Stocks. Metric New Spread (%Increase | value)

New Spread (%Increase | value) is the second metric I will explain. We follow the same process as we did for the previous metric.

Continue with the same example “Enbridge Series 17, Cumulative Redeemable Preference Shares”.

 

Metric Components

For this and all resets, 2 components make up the valuation process:

  1. The purchase price.
  2. The “SPREAD“.  In this case 2.4%. We call this “ISSUE: SPREAD”.

Example setup

Same setup for BuyerA  and BuyerB  as before.  The important point here is to understand the affect the purchase price has on the Spread.

metric formula and calculations

Firstly, we determine what the “spread increase %” of (41%) 

The calculation is: “spread increase %” = (FACE VALUE – MARKET PRICE) / FACE VALUE

Face Value Market Price

spread increase %

 $    25.00  $      14.72 41%

 The new spread increase for BuyerB is 41% due to the purchase price of $14.72.

Secondly, calculate the SPREAD INCREASE TO VALUE (3.5%)

The calcuation is:  “NEW SPREAD %” = (“ISSUE SPREAD” * “SPREAD INCREASE %”) + “ISSUE SPREAD” 

ISSUE SPREAD Spread Increase % New Spread %
2.40% 41% 3.38%

Conclusion – How To Find Undervalued Preferred Stocks

We provide this metric with all of our compare tools.  As a result, locating undervalued stocks is easy. Once you understand the metric, use it to make quick evaluations across issuers / sectors / categories of preferreds.

Finding Undervalued Preferred Stocks, in other words, picking up a preferred stock at a deep discount has additional benefits, other than the standard value related benefits.

  • When rates go up, issuers are looking to redeem their highest yielding preferreds. Having picked a deep discounted value preferred means the “BASE SPREAD” is not that high and most likely the issuer will not be redeeming the preferred. Meanwhile you are still collecting a high yield because of when you purchased the share.
  • These types of shares are most likely to generate the highest capital gains. As rates go up all preferreds have a “ceiling”, the face value.

Canadian Preferred Shares – Mission

Our mission is to provide the average investor with the knowledge, up to date information, latest trends, data and tools to select the best preferreds to purchase or sell today.

Without tools like the ones we provide here, its simply not possible to make an educated decision, thus keeping most individual investors away. Our tools provide an overall view, of the preferreds market. With a few clicks you can easily locate today’s best preferreds within a sector/category or across the whole market.

Using our homepage as a starting point you can access all of our tools.

3 Comments

  1. Frank

    I think this article is very informative. There are two points that I would
    like to give my opinion.
    1. Metric Formula and Calculations
    The “RATE INCREASE PERCENT (119%)” IS CONFUSING.
    Use the example given in the article, I get the following calculations:
    = ($25 x (1.59% + 2.4% )/ $14.56) – 1.59% (RATE INCREASE To VALUE (5.26%)
    = (25 x 1.59% + 25 x 2.4% – 14.56 x 1.59%)/14.56
    =((25 – 14.56) x 1.59% + 25 x 2.4%)/14.56
    So, at this point, the entire formula is not meaningful. For the numerator it is the difference of the face values and the current price multiplied by the BOC rate – face value times the spread.
    I think the reasonable assessment would be the following:
    Face value 25
    Year issued
    dividend %
    Face value dividend and % 5 year BOC 1.59% + spread 2.4%,
    25 x (1.59% + 2.4%) = $1, 1/25 = 4%
    Market price* 14.56
    Market price dividend % $1/$14,56 = 6.87%
    Dividend % increase in % (6.87 – 4) / 4 = 2.87 / 4 = 71.75% increase

    • The reader must be careful in assessing the market value when it is much lower than the face value. There could be several reasons; one of them could be in the future, the share will be converted into floating-rate despite it was originally issued as a perpetual share – the rate is not perpetual.
    The reader can find out details for the share’s prospectus.
    • The issued company may not have an excellent evaluation form the analysts.

    Reply
    • AAlex

      Frank Thank you for your input. You have made number of good points. I have reviewed your comments and I will be updating the article to reflect your points. In addition we will modify the Formula for this metric in the model. I will also be adding a new metric showing what the new spread is, based on the current price of the stock.

      Reply
      • AAlex

        Post and Formula have been updated.

        Reply

Submit a Comment

Your email address will not be published. Required fields are marked *