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s of a business, to be touched upon later. There is no one, simple answer to the questions that we have raised. Actually, if the subsidiary could be wound up without an adverse effect upon the rest of the business, it would be logical to view such losses as temporary—since good sense would dictate that in a short time the subsidiary must either become prof- itable or be disposed of. But if there are important business relations between the parent company and the subsidiary, e.g., if the latter affords an outlet for goods or supplies cheap materials or absorbs an important share of the overhead, then the termination of its losses is not so simple a matter. It may turn out, upon further analysis, that all or a good part of the subsidiary’s loss is a necessary factor in the parent company’s profit. It is not an easy task to determine just what business relationships are
Manual of Investments (Steam Railroads), 1931. The Wabash owned 99% of both the pre- ferred and the common stock of the Ann Arbor. In December 1930 the Ann Arbor directors declared a $5 dividend per share on the preferred and a $27 dividend per share on the com- mon. This action was taken in the face of a working-capital deficit and net earnings available of little over 10% of the dividends thus declared. Neither dividend was ever paid. This maneuver, however, enabled the Wabash to credit its share of the dividends declared to its income account as “dividend income” to the extent of $1,073,455, which was sufficient to raise the fixed-charge coverage of the Wabash from about 1.3 times to a figure slightly in excess of 1.5 times.
involved in each instance. Like so many other elements in analysis, this point usually requires an investigation going well beyond the reported figures. The following examples will illustrate the type of situation and analysis with which we have been dealing.
Example A: Purity Bakeries Corporation. This large maker of bread and cake operates through a number of subsidiaries, o |
ent to raise the fixed-charge coverage of the Wabash from about 1.3 times to a figure slightly in excess of 1.5 times.
involved in each instance. Like so many other elements in analysis, this point usually requires an investigation going well beyond the reported figures. The following examples will illustrate the type of situation and analysis with which we have been dealing.
Example A: Purity Bakeries Corporation. This large maker of bread and cake operates through a number of subsidiaries, of which one of the largest is Cushman’s Sons, Inc., of New York. Cushman’s has outstanding
$7 and $8 cumulative preferred stock, not guaranteed by Purity. The annual reports of Purity are on a consolidated basis and show earnings after deduction of full dividends on those Cushman’s preferred shares not owned by Purity, whether earned or paid. The separate reports of Cush- man’s reveal that between 1934 and 1937 its operations resulted in a considerable loss to Purity, on its accounting basis, viz.:
(000 OMITTED)
Year
Purity net income as reported Loss of Cushman’s after full preferred dividends Purity earnings excluding Cush- man’s operations
1937 $463 $426 $889
1936 690 620 1,310
1935 225 (d.) 930 678
1934 209 173 382
Average 4 years 278 537 815
Per share of Purity 0.36 0.71 1.06
The earnings are thus seen to be three times as large excluding Cush- man’s as they were including Cushman’s. Could the analyst have reasoned that the former provides the truer measure of Purity’s earning power, since the company can be expected either again to earn money from that sub- sidiary (as it had earned it in the past up to 1934) or to drop it? The ques- tion of inter-corporate relationships would have to be considered. A note in the 1937 report of Cushman’s indicated that Purity was making a fairly large service charge in connection with its subsidiaries’ operations, which suggests that Cushman’s might be of some extra value in absorbing over- head. This matter would call for a car |
ning power, since the company can be expected either again to earn money from that sub- sidiary (as it had earned it in the past up to 1934) or to drop it? The ques- tion of inter-corporate relationships would have to be considered. A note in the 1937 report of Cushman’s indicated that Purity was making a fairly large service charge in connection with its subsidiaries’ operations, which suggests that Cushman’s might be of some extra value in absorbing over- head. This matter would call for a careful inquiry.
But the report for the next year, 1938, showed, first, that Cushman’s had earned the preferred dividend deduction, and secondly, that two unprofitable retail plants (in Philadelphia and Chicago) had been closed. Subject to further investigation, therefore, the analyst might well infer that the subsidiary’s losses were nonpermanent in nature and that the reported results for 1934–1937 are to be viewed with this point in mind. Example B: Lehigh Coal and Navigation Company. This enterprise has derived its income from various sources, chief of which has been the lease of its railroad property to the Central Railroad of New Jersey for an annual rental of $2,268,000. Its next largest holding consists of anthracite coal mines, which since 1930 have been operated at a loss. In 1937 this loss was equivalent to about 90 cents per share of Lehigh stock. As a result the company reported a consolidated net loss of $306,000 for the year, as contrasted with a profit on a parent-company basis only of $1,125,000,
or 64 cents per share.
But in this case the analyst could not safely make the assumption that the Lehigh stock was not worth less by reason of its ownership of the min- ing properties than it would be worth without them. Operation of the mines supplied an important tonnage to the railroad division. If the mines were shut down, the ability of the Jersey Central to pay the annual rental might have been critically impaired, especially since the lessee road had been doing |
y basis only of $1,125,000,
or 64 cents per share.
But in this case the analyst could not safely make the assumption that the Lehigh stock was not worth less by reason of its ownership of the min- ing properties than it would be worth without them. Operation of the mines supplied an important tonnage to the railroad division. If the mines were shut down, the ability of the Jersey Central to pay the annual rental might have been critically impaired, especially since the lessee road had been doing poorly for some years past. (In fact the claim was later made by the Jersey Central that the Lehigh Coal and Navigation was obligated in connection with the lease to supply a certain tonnage from its coal properties). Hence, in this rather complicated set-up the investor could not safely go behind the consolidated results, including the losses of the anthracite subsidiary.
Example C: Barnsdall Oil Company. We have here a situation oppo- site from the other two. Barnsdall Oil owned both refining and produc- ing properties, the latter profitable, the former unprofitable. In 1935 it segregated the refineries (and marketing units) in a separate company, of which it distributed the common stock to its own stockholders, retain- ing, however, the preferred stock and substantial claims against the new company. In 1936–1938 the refineries and stations continued to lose; Barnsdall Oil advanced considerable sums to cover these losses and wrote them off by charges first against capital surplus and then against earned surplus. On the other hand, its income account, freed from the burden of
these refining losses, showed profits from producing operations at a steady rate from June 1, 1933, to the end of 1938.
In 1939, however, the New York Stock Exchange called upon the com- pany to correct its statements to stockholders by advising them of the effect upon the reported profits of charging there-against the write-downs of the investment in the refining company. These losses would have red |
d then against earned surplus. On the other hand, its income account, freed from the burden of
these refining losses, showed profits from producing operations at a steady rate from June 1, 1933, to the end of 1938.
In 1939, however, the New York Stock Exchange called upon the com- pany to correct its statements to stockholders by advising them of the effect upon the reported profits of charging there-against the write-downs of the investment in the refining company. These losses would have reduced the indicated profits by more than one-third.
It is clear, from the standpoint of proper accounting, that as long as a company continues to control an unprofitable division, its losses must be shown as deductions from its other earnings. The analyst must decide what the chances are of terminating the losses in the future, and view the current price of the stock accordingly. The method followed by the Barns- dall Oil Company appears therefore clearly open to criticism, since it served merely to terminate the reporting of its refining losses without really terminating the losses themselves. (At the end of 1939 the company set steps into motion for an apparent complete divorcement and sale of the refining and marketing divisions.)
Summary. To avoid leaving this point in confusion, we shall summa- rize our treatment by suggesting:
1. In the first instance, subsidiary losses are to be deducted in every analysis.
2. If the amount involved is significant, the analyst should investigate whether or not the losses may be subject to early termination.
3. If the result of this examination is favorable, the analyst may consider all or part of the subsidiary’s loss as the equivalent of a nonrecurring item.
Chapter 34
THE RELATION OF DEPRECIATION AND
SIMILAR CHARGES TO EARNING POWER
A CRITICAL analysis of an income account must pay particular attention to the amounts deducted for depreciation and kindred charges. These items differ from ordinary operating expenses in that they do |
hether or not the losses may be subject to early termination.
3. If the result of this examination is favorable, the analyst may consider all or part of the subsidiary’s loss as the equivalent of a nonrecurring item.
Chapter 34
THE RELATION OF DEPRECIATION AND
SIMILAR CHARGES TO EARNING POWER
A CRITICAL analysis of an income account must pay particular attention to the amounts deducted for depreciation and kindred charges. These items differ from ordinary operating expenses in that they do not signify a current and corresponding outlay of cash. They represent the estimated shrinkage in the value of the fixed or capital assets, due to wearing out, to using up or to their approaching extinction for whatever cause. The important charges of this character may be classified as follows:
1. Depreciation (and obsolescence), replacements, renewals or retirements.
2. Depletion or exhaustion.
3. Amortization of leaseholds, leasehold improvements, licenses, etc.
4. Amortization of patents.
All these items may properly be embraced under the title “amortization,” but we shall sometimes refer to them generically as “depreciation items,” or simply as “depreciation,” because the latter is a more familiar term.
Leading Questions Relative to Depreciation. The accounting the- ory that governs depreciation charges is simple enough. If a capital asset has a limited life, provision must be made to write off the cost of that asset by charges against earnings distributed over the period of its life. But behind this innocent statement lie complications of a threefold character. First we find that accounting rules themselves may permit a value other than cost as the base for the amortization charge. Second, we find many ways in which companies fail to follow accepted accounting practice in stating their depreciation deduction in the income account. Third, there are occasions when an allowance that may be justified from an account- ing standpoint will fail to meet the situation properly f |
ife. But behind this innocent statement lie complications of a threefold character. First we find that accounting rules themselves may permit a value other than cost as the base for the amortization charge. Second, we find many ways in which companies fail to follow accepted accounting practice in stating their depreciation deduction in the income account. Third, there are occasions when an allowance that may be justified from an account- ing standpoint will fail to meet the situation properly from an investment standpoint. These problems will engage our attention in this and the next
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two chapters. Our discussion will be directed first towards industrial com- panies generally, following which we shall consider special aspects having to do with oil companies, mining companies and public utilities.1
THE DEPRECIATION BASE
Depreciation Base Other than Cost. There is support in account- ing circles for the theory that the function of the depreciation allowance is to provide for the replacement of the asset at the end of its life rather than merely to write off its cost. If this idea were actually followed, the current or expected future replacement cost would be the basis for the depreciation charge, and it would vary not only with the value of the iden- tical asset but also with changes in the character of the item that is expected to replace the one worn out.
Whatever may be said for or against this theory,2 it is virtually never followed in the form stated. But we do meet in practice with a variant of the idea, viz., the substitution of the replacement value of all the fixed assets as of a given date in place of cost on the balance sheet, followed usually by annual depreciation charges based on the new value.
Since 1914 there have been two waves of such revaluations. The first, taking place in the 1920’s, marked up prewar costs to the higher values |
Whatever may be said for or against this theory,2 it is virtually never followed in the form stated. But we do meet in practice with a variant of the idea, viz., the substitution of the replacement value of all the fixed assets as of a given date in place of cost on the balance sheet, followed usually by annual depreciation charges based on the new value.
Since 1914 there have been two waves of such revaluations. The first, taking place in the 1920’s, marked up prewar costs to the higher values cur- rently prevailing. The second, appearing in 1931–1933, marked down prop- erty accounts to the much lower valuations associated with the depression.3 Examples: In 1926 American Ice Company wrote up its fixed assets
by $7,868,000, and in 1935 it wrote them down correspondingly to restore the valuations to a cost basis. The 1926 write-up resulted in larger depre- ciation charges thereafter against income, and the 1935 reduction resulted in lower depreciation charges. In 1933 American Locomotive Company
1 With a very few exceptions the railroads charge depreciation only on their equipment (including this item in the maintenance charges). For the year 1937 Class I railroads charged a total of $191,798,000 for depreciation of equipment and only $5,236,000 for depreciation of way and structures.
2 In our view it is at once simpler and more logical to base depreciation on original cost. Replacement cost should affect the accounts after replacement takes place (which may never happen) rather than before.
3 See Fabricant, Solomon, “Revaluations of Fixed Assets, 1925–1934” (National Bureau of Economic Research Bulletin 62, 1936), and Capital Consumption and Adjustment, National Bureau of Economic Research, Chap. XII, 1938.
reduced the stated value of its stock from $50 to $5 a share and utilized most of the capital surplus thus created to write down fixed properties by nearly $26,000,000 and its investment in General Steel Castings Corpo- ration by about $6,200,000. The net eff |
ther than before.
3 See Fabricant, Solomon, “Revaluations of Fixed Assets, 1925–1934” (National Bureau of Economic Research Bulletin 62, 1936), and Capital Consumption and Adjustment, National Bureau of Economic Research, Chap. XII, 1938.
reduced the stated value of its stock from $50 to $5 a share and utilized most of the capital surplus thus created to write down fixed properties by nearly $26,000,000 and its investment in General Steel Castings Corpo- ration by about $6,200,000. The net effect on the income account was to reduce depreciation charges to about 40% of their former level.
There is some criticism in accounting circles of the propriety of such sporadic changes in the depreciation base from original cost. In our opin- ion they are not objectionable provided:
1. The new values are set up in the bona fide conviction that they represent existing realities more fairly than the old values.
2. Proper depreciation against these new values is charged in the income account.
In many cases, however, we find that companies revaluing their fixed assets fail to observe one or the other of these conditions.
Mark-downs to Reduce Depreciation Charges. Perhaps the most striking phenomenon in the field of depreciation accounting is the recent marking down of the fixed assets, not in the interests of conservatism but with the precisely opposite intent of making a better earnings exhibit and thereby increasing the apparent value of the shares.
We believe that it will be more convenient for the reader if we defer con- sideration of the significance to security analysis of these devices until our chapter devoted to “Amortization Charges from the Investor’s Standpoint.” At this time, since we are dealing with accounting methods, we shall merely remark that in our opinion excessive write-downs of fixed assets, for the avowed or obvious purpose of decreasing depreciation and increasing reported earnings, constitute an inexcusable subterfuge and should not be condoned by the ac |
ient for the reader if we defer con- sideration of the significance to security analysis of these devices until our chapter devoted to “Amortization Charges from the Investor’s Standpoint.” At this time, since we are dealing with accounting methods, we shall merely remark that in our opinion excessive write-downs of fixed assets, for the avowed or obvious purpose of decreasing depreciation and increasing reported earnings, constitute an inexcusable subterfuge and should not be condoned by the accounting profession. Registration statements submit- ted to the S.E.C. include a statement of how much lower the earnings would have been if the former plant values had been retained. We think that such information should also appear as a footnote to the income account in the annual reports to stockholders, but it would be better practice still if accountants refused to certify a report containing such mark-downs and insisted on restoration of the proper figures to the company’s accounts.
Balance Sheet–Income Account Discrepancies. Many corpora- tions that have marked up their fixed assets fail to increase correspond- ingly their depreciation charges against the income account. They are in
effect attempting to get the benefit of the higher valuation in their balance sheet without accepting the burden of consequently higher depreciation charges against earnings. This practice has been especially prevalent in the case of mining and oil companies. Two examples drawn from the general industrial field are given here:
Examples: Hall Printing Company wrote up its property account by
$6,222,000 in 1926 and 1931, crediting this “appraisal increment” to cap- ital surplus. Depreciation on this appreciated value was then charged to capital surplus, instead of to income; e.g., typically, in the year ended March 1938 the company charged $406,000 for such depreciation against surplus and $864,000 for “regular” depreciation against income. In April 1938 the balance of the appraisal increme |
ustrial field are given here:
Examples: Hall Printing Company wrote up its property account by
$6,222,000 in 1926 and 1931, crediting this “appraisal increment” to cap- ital surplus. Depreciation on this appreciated value was then charged to capital surplus, instead of to income; e.g., typically, in the year ended March 1938 the company charged $406,000 for such depreciation against surplus and $864,000 for “regular” depreciation against income. In April 1938 the balance of the appraisal increment was eliminated by writing down both property account and capital surplus; and the special depreci- ation charge was then discontinued.
Borg Warner has been charging about $102,000 per annum since 1935 (and various amounts in prior years) to “Appreciation Surplus,” instead of to income, to amortize a write-up of fixed assets made in 1927.
It should be obvious that no company should use one set of values for its balance sheet and another for its income account. The more recent tendency is to correct these disparities by eliminating the previous write- up from the balance sheet, thus returning to original cost.
THE RATE OF DEPRECIATION. STANDARD
AND NONSTANDARD PRACTICE
1. As Shown by Listing Statements. The vast majority of industrial companies follow the standard policy of charging an appropriate depre- ciation rate against each class of depreciable asset. The analyst can read- ily check this fact by reference to New York Stock Exchange listing applications or to a prospectus or registration statement.
Examples: If standard methods are followed, they are likely to be announced in somewhat the following manner:
(From listing application of Electric Storage Battery Company, dated December 17, 1928.)
The policy of this Company in regard to depreciation … is as follows: On buildings the term of life is twenty to thirty-three years, depending upon the character of construction. Machinery, tools and fixtures are written off at the rate of one to ten years, depending upon the ch |
gistration statement.
Examples: If standard methods are followed, they are likely to be announced in somewhat the following manner:
(From listing application of Electric Storage Battery Company, dated December 17, 1928.)
The policy of this Company in regard to depreciation … is as follows: On buildings the term of life is twenty to thirty-three years, depending upon the character of construction. Machinery, tools and fixtures are written off at the rate of one to ten years, depending upon the character of the equipment.
Office furniture and fixtures are written off in ten years. On all depreciable properties rates are determined by actual experience and engineers’ estimates as to the productive life of the equipment. In respect to depreciation of cur- rent assets, a reserve is set aside to cover probable loss from bad debts.
(From the listing application of Midland Steel Products Company, dated February 11, 1930.)
The following are the rates of depreciation used:
Rate of depreciation per year, %
Buildings 2
Grounds, driveways and walks 2
Machinery 7
Furniture and fixtures 10
Railroad sidings 2
Automobiles and trucks 25
Tools and dies—amortized over life of job when number of units required can be determined, otherwise written off at close of each fiscal year.
These rates have been used by the Company for several years, being standard practice in the industry.
The rates are based upon the estimated life of the respective property involved. Thus, with respect to buildings, the cost is depreciated, over 50 years; grounds, driveways, and walks, over 50 years; machinery over 14 years; furniture and fixtures, over 10 years; railroad sidings, over 50 years. No residual value at the expiration of said periods is considered in determining the rates used.
In contrast with this standard policy, now all but universally followed, we may point to the questionable practice on this important point for- merly resorted to by such important companies as American Car and Foundry, A |
the cost is depreciated, over 50 years; grounds, driveways, and walks, over 50 years; machinery over 14 years; furniture and fixtures, over 10 years; railroad sidings, over 50 years. No residual value at the expiration of said periods is considered in determining the rates used.
In contrast with this standard policy, now all but universally followed, we may point to the questionable practice on this important point for- merly resorted to by such important companies as American Car and Foundry, American Sugar Refining and Baldwin Locomotive Works.
The American Sugar Refining Company’s listing application, dated December 6, 1923, contained the following statement:
The Company maintains a very liberal policy as to depreciation as shown by the annual profit and loss statement of past years. The value of its properties is at all times fully maintained by the making of all needful and proper repairs thereto and renewals and replacements thereof.
This declaration sounds reassuring, but it is far too indefinite to sat- isfy the analyst. The actual depreciation charges, as shown in the follow- ing record, disclose an unusually arbitrary and erratic policy.
ANNUAL CHARGES BY AMERICAN SUGAR REFINING COMPANY FOR DEPRECIATION
Year Charged to income Charged to surplus
1916–1920 $2,000,000 None
1921 None None
1922–1923 1,000,000 None
1924 None None
1925 1,000,000 None
1926 1,000,000 $2,000,000
1927 1,000,000 1,000,000
1928 1,250,000 500,000
1929 1,000,000 500,000
1930 1,000,000 542,631
1931 1,000,000 None
1932 1,000,000 None
The additional charges to surplus made in the years 1926–1930, inclu- sive, appear to strengthen our contention that American Sugar’s depreci- ation allowances have been both arbitrary and inadequate.
The American Car and Foundry’s application, dated April 2, 1925, contains the following:
The Company has no depreciation account as such. However, its equivalent is found in the policy and the practice of the Company to maintain at all times its plants and |
1931 1,000,000 None
1932 1,000,000 None
The additional charges to surplus made in the years 1926–1930, inclu- sive, appear to strengthen our contention that American Sugar’s depreci- ation allowances have been both arbitrary and inadequate.
The American Car and Foundry’s application, dated April 2, 1925, contains the following:
The Company has no depreciation account as such. However, its equivalent is found in the policy and the practice of the Company to maintain at all times its plants and properties in first class physical condition and in a high state of efficiency by repairing, renewing and replacing equipment and build- ings as their physical conditions may require, and by replacing facilities with those of more modern type, when such action results in more economical production. This procedure amply covers depreciation and obsolescence and the cost is charged to Operating Expenses.
Here again a sceptical attitude on the part of the analyst is “amply” war- ranted. The same is true in respect of American Can which managed— inexplicably—to avoid all reference to its depreciation policy in its listing
application dated February 26, 1926, although it did mention that the com- pany had spent approximately $50,000,000 on extensions and improve- ment of properties since February 1907 and that “during this period properties have been depreciated by at least $20,000,000.”
Baldwin Locomotive Works, in its listing application dated October 3, 1929, makes the following rather astonishing statement on depreciation:
The amount of the depreciation upon plant and equipment as determined by the Federal Government for the five years 1924 to 1928 inclusive has totaled $5,112,258.09 which has been deducted either from income or sur- plus as follows:
Year From income From surplus Total depreciation
1924 $600,000 None $600,000.00
1925 None None None
1926 None None None
1927 1,000,000 $2,637,881.01 3,637,881.01
1928 600,000 274,377.08 874,377.08
$2,200,000 $2,912,258. |
astonishing statement on depreciation:
The amount of the depreciation upon plant and equipment as determined by the Federal Government for the five years 1924 to 1928 inclusive has totaled $5,112,258.09 which has been deducted either from income or sur- plus as follows:
Year From income From surplus Total depreciation
1924 $600,000 None $600,000.00
1925 None None None
1926 None None None
1927 1,000,000 $2,637,881.01 3,637,881.01
1928 600,000 274,377.08 874,377.08
$2,200,000 $2,912,258.09 $5,112,258.09
It is expected that in future years the amount of depreciation based upon the estimated useful life of depreciable properties as determined by the Federal Government, allowed by the Commissioner of Taxes as a proper deduction from income and agreed to by our engineers, will govern the amount to be used by the Works in its calculation of depreciation.
Evidently the income statements of Baldwin for this period were any- thing but accurate. The average annual earnings per share of common stock for 1924–1928, as reported to the stockholders, were strikingly higher than the correct figure, as shown at the top of page 460.
2. As Shown by Comparisons of Two Companies. When the ana- lyst knows that a company’s depreciation policy differs from the standard, there is special reason to check the adequacy of the allowance. Comparison with a single company in the same field may yield significant results, as is shown by the table in the middle of page 460 respecting American Sugar and American Car and Foundry.
EARNINGS PER SHARE OF COMMON
Year
As reported As corrected for annual depreciation charge of
$1,022,000
1924 $0.40(d) $2.51(d)
1925 6.02(d) 11.13(d)
1926 22.42 17.31
1927 5.21 5.10
1928 5.34(d) 7.45(d)
5-year average $3.33 $0.06
Company Average property account
(net) 1928–1932 Average depreciation charge
1928–1932 % of depreciation charge to property account
American Sugar Refining $60,665,000 $1,050,000* 1.73†
National Sugar Refining 19,250,000‡ 922,000‡ |
and American Car and Foundry.
EARNINGS PER SHARE OF COMMON
Year
As reported As corrected for annual depreciation charge of
$1,022,000
1924 $0.40(d) $2.51(d)
1925 6.02(d) 11.13(d)
1926 22.42 17.31
1927 5.21 5.10
1928 5.34(d) 7.45(d)
5-year average $3.33 $0.06
Company Average property account
(net) 1928–1932 Average depreciation charge
1928–1932 % of depreciation charge to property account
American Sugar Refining $60,665,000 $1,050,000* 1.73†
National Sugar Refining 19,250,000‡ 922,000‡ 4.79‡
American Car and Foundry 72,000,000 1,186,000§ 1.65
American Steel Foundries 31,000,000 1,136,000 3.66
* Exclusive of depreciation charged to surplus. Including the latter, this figure would be $1,358,500.
† Including depreciation charged to surplus this figure would be 2.24%.
‡ Based on the four years 1929–1932, inclusive. Figure for 1928 unavailable.
§ Estimated at one-half of the expenditures for renewals and repairs. In the case of United States Steel for the period 1901–1933, the charge for depreciation averaged about 40% of the total allowances for both maintenance and depreciation.
Both comparatively and absolutely the depreciation allowances made by American Sugar and American Car and Foundry appear to have been inadequate.4
4 For examples of insufficient charges and charges less than income tax deductions by industrial companies see: Harbison-Walker Refractories Company charge of $296,000 in 1936, termed “grossly inadequate” by new management and revised to $472,000;
McKeesport Tin Plate Corporation report for 1937 stating that the charge on the income tax return was $803,000 vs. $425,000 in statement to stockholders. Similarly, National Enameling and Stamping Company for each year 1935–1937 charged about $185,000 in its income account as contrasted with about $280,000 on its tax return. In 1938 insufficient depreciation for 1933–1937 was cured by a charge of $443,000 to surplus. The auditors for the Cudahy Packing Company stated in the certificate accompanyi |
cKeesport Tin Plate Corporation report for 1937 stating that the charge on the income tax return was $803,000 vs. $425,000 in statement to stockholders. Similarly, National Enameling and Stamping Company for each year 1935–1937 charged about $185,000 in its income account as contrasted with about $280,000 on its tax return. In 1938 insufficient depreciation for 1933–1937 was cured by a charge of $443,000 to surplus. The auditors for the Cudahy Packing Company stated in the certificate accompanying the 1939 report that in their opinion the reserves for depreciation set up by the company in years prior to Oct. 29, 1938, were inadequate.
Depreciation Charges Often an Issue in Mergers. Comparative depreciation charges at times become quite an issue in determining the fairness of proposed terms of consolidation.
Example: In 1924 a merger plan was announced embracing the Chesa- peake and Ohio, Hocking Valley, Pere Marquette, “Nickel Plate,” and Erie railroads. Some Chesapeake and Ohio stockholders dissented, and they convinced the Interstate Commerce Commission that the terms of the consolidation were highly unfair to their road. Among other matters they pointed out that the earnings of Chesapeake and Ohio in the preceding three years had in reality been much higher than stated, due to the unusu- ally heavy charges made against them for depreciation and retirement of equipment.5 A similar objection was made in connection with the pro- jected merger of Bethlehem Steel and Youngstown Sheet and Tube in 1929, which plan was also defeated. Some figures on these two steel pro- ducers are given as shown in the table on p. 462.
Concealed Depreciation. That nothing can be taken for granted in security analysis is shown by the strange case of American Can, which until 1937 had failed to reveal details of its depreciation policy to its shareholders. During the years 1922–1936 it deducted anually a flat
$2,000,000 for this purpose. A comparison with Continental Can— which charged a |
wn Sheet and Tube in 1929, which plan was also defeated. Some figures on these two steel pro- ducers are given as shown in the table on p. 462.
Concealed Depreciation. That nothing can be taken for granted in security analysis is shown by the strange case of American Can, which until 1937 had failed to reveal details of its depreciation policy to its shareholders. During the years 1922–1936 it deducted anually a flat
$2,000,000 for this purpose. A comparison with Continental Can— which charged about the same amount against a much smaller plant investment—would have suggested that American Can’s earning power had been overstated. But the annual report for 1934 disclosed to stock- holders for the first time that the company had also been charging sums to operating expenses for “replacements,” without giving the amount. The fact (but not the amounts) that such charges had been made in 1935 and 1936 was also revealed in those years. Meanwhile Form 10-K for 1935, filed with the S.E.C., revealed that the amount of these extra
Conversely, for cases of excessive depreciation, note: Depreciation charges of Acme Steel for 1932–1935 were found by the federal government to have been $555,000 too high. This amount, less income tax thereon of $104,000, was credited to surplus in 1936. (This is almost the exact opposite of the National Enameling case.) Chicago Yellow Cab Company in 1938 credited to surplus $483,000 for excess depreciation in former years.
5 Large expenditures made by Chesapeake and Ohio upon its equipment in 1926–1928 and charged to operating expense were later claimed by the Interstate Commerce Commission to represent capital outlays. In 1933 this controversy was taken into the courts, and the Interstate Commerce Commission was sustained.
charges was about $2,400,000. Finally the annual report for 1937 advised the stockholders that the corresponding extra charge-off amounted to approximately $3,275,000 for the year 1936. Beginning with 1937 the company made “r |
peake and Ohio upon its equipment in 1926–1928 and charged to operating expense were later claimed by the Interstate Commerce Commission to represent capital outlays. In 1933 this controversy was taken into the courts, and the Interstate Commerce Commission was sustained.
charges was about $2,400,000. Finally the annual report for 1937 advised the stockholders that the corresponding extra charge-off amounted to approximately $3,275,000 for the year 1936. Beginning with 1937 the company made “regular” depreciation charges, amounting to $5,702,000 in that year and to $6,085,000 in 1938. Thus, by easy stages, the owners of the business were told the facts of life bearing on their property.
1928
Bethlehem Steel Youngstown Sheet & Tube
Property account, Dec. 31, 1927 $673,000,000 $204,000,000
Sales 295,000,000 141,000,00
Depreciation, depletion, and obsolescence 13,658,000 8,321,000
Ratio: depreciation to property account 2.03% 4.08%
Ratio: depreciation to sales 4.63% 5.90%
In the light of this later disclosure, the earlier inference6 that Ameri- can Can had understated its depreciation charges must give way to the remark that the company had failed to reveal the facts.
A Case of Excessive Depreciation Charges Concealed by Accounting Methods. The American Can example suggests compar- ison with the earlier practice of National Biscuit Company, an enterprise controlled largely by the same interests. For many years prior to 1922 the company was constantly adding to the number of its factories, but its property account failed to show any appreciable increase, except in the single year 1920. The reports to stockholders were supremely ambiguous
on the matter of depreciation charges,7 but according to the financial manuals the company’s policy was as follows: “Depreciation is $300,000 per annum, and all items of replacement and building alterations are charged direct to operating expense.”
It is difficult to avoid the conclusion, however, that the capital invest- ments in |
f its factories, but its property account failed to show any appreciable increase, except in the single year 1920. The reports to stockholders were supremely ambiguous
on the matter of depreciation charges,7 but according to the financial manuals the company’s policy was as follows: “Depreciation is $300,000 per annum, and all items of replacement and building alterations are charged direct to operating expense.”
It is difficult to avoid the conclusion, however, that the capital invest- ments in additional plants were actually being charged against the profits
6 Drawn in the 1934 edition of this book.
7 Prior to 1919, the company’s balance sheet each year stated its fixed assets “Less Deprecia- tion Account—$300,000.” Evidently this was the deduction for the current year and not the amount accumulated.
NATIONAL BISCUIT COMPANY
Year ended Earnings for common stock Net plant account at end of year
Jan. 31, 1911 $2,883,000 $53,159,000
1912 2,937,000 53,464,000
1913 2,803,000 53,740,000
1914 3,432,000 54,777,000
1915 2,784,000 54,886,000
1916 2,393,000 55,207,000
1917 2,843,000 55,484,000
Dec. 31, 1917 2,886,000 (11 mo.) 53,231,000
1918 3,400,000 52,678,000
1919 3,614,000 53,955,000
1920 3,807,000 57,788,000
1921 3,941,000 57,925,000
1922 9,289,000 61,700,000
1923 10,357,000 64,400,000
1924 11,145,000 67,292,000
1925 11,845,000 69,745,000
and that the real earnings were in all probability much larger than those reported to the public. Coincident with the issuance of seven shares of stock for one and the tripling of the cash-dividend rate in 1922, this policy of understating earnings was terminated. The result was a sudden doubling of the apparent earning power, accompanied by an equally sudden expansion in the plant account. The contrast between the two periods is shown forcibly in the table on this page.
Failure to State Depreciation Charges. Prior to the S.E.C. regula- tion some of the important companies reported earnings after deprecia- tion but failed to stat |
hares of stock for one and the tripling of the cash-dividend rate in 1922, this policy of understating earnings was terminated. The result was a sudden doubling of the apparent earning power, accompanied by an equally sudden expansion in the plant account. The contrast between the two periods is shown forcibly in the table on this page.
Failure to State Depreciation Charges. Prior to the S.E.C. regula- tion some of the important companies reported earnings after deprecia- tion but failed to state the amount deducted for this purpose. Fortunately, this information must now be supplied in the case of every registered company.8
8 Allied Chemical and Dye Corporation endeavored to have this and other data held confi- dential, but after considerable delay it was made public (in 1938). This company, like a few others, still excludes its sales and depreciation figures from its reports to stockholders, but this important information is available in the annual reports to the S.E.C. (Form 10-K).
AMORTIZATION CHARGES OF OIL
AND MINING COMPANIES
These important sectors of the industrial field are subject to special fac- tors bearing on amortization. In addition to depreciation in the ordinary sense—which they usually calculate in the same way as do other compa- nies9 they must allow for depletion of their ore or oil reserves. In the case of mining concerns there is also the factor of development expense. Oil producers, on the other hand, have additional charges for intangible drilling costs and for unproductive leases. These items are important in their bearing on the true profits, and they are troublesome because of the varying methods that are followed by different enterprises.
Depletion Charges of Mining Companies. Depletion represents the using up of capital assets by turning them into products for sale. It applies to companies producing metals, oil and gas, sulphur, timber, etc. As the holdings, or reserves, of these products are exhausted, their value must gradually b |
g costs and for unproductive leases. These items are important in their bearing on the true profits, and they are troublesome because of the varying methods that are followed by different enterprises.
Depletion Charges of Mining Companies. Depletion represents the using up of capital assets by turning them into products for sale. It applies to companies producing metals, oil and gas, sulphur, timber, etc. As the holdings, or reserves, of these products are exhausted, their value must gradually be written off through charges against earnings. In the case of the older mining companies (including particularly the copper and sul- phur producers) the depletion charges are determined by certain techni- cal requirements of the federal income tax law, which rest upon the amount and value of the reserves as they were supposed to exist on March 1, 1913, or by applying certain percentages to the value of the product. Because of the artificial base used in these computations, many compa- nies have omitted the depletion charge from their reports to stockholders.
Independent Calculation by Investor Necessary. As we shall show later, the investor in a mining concern must ordinarily compute his own depletion allowance, based upon the amount that he has paid for his share of the mining property. Consequently a depletion charge based either on the company’s original book cost or on the special figure set up for income-tax purposes would be confusing rather than helpful. The omis- sion of the depletion charge of mining companies is not to be criticized, therefore; but the stockholder in such enterprises must be well aware of the fact in studying their reports. Furthermore, in any comparison of
9 However, the cost of equipment and materials on oil-producing properties is often written off through the depletion charge (which is based on the barrels produced) instead of the depreciation account (which is based on the time elapsing).
mining companies a proper distinction must be drawn |
epletion charge of mining companies is not to be criticized, therefore; but the stockholder in such enterprises must be well aware of the fact in studying their reports. Furthermore, in any comparison of
9 However, the cost of equipment and materials on oil-producing properties is often written off through the depletion charge (which is based on the barrels produced) instead of the depreciation account (which is based on the time elapsing).
mining companies a proper distinction must be drawn between those which do and those which do not deduct their depletion charges in reporting their earnings. Following are some examples of companies that pursue one or the other policy:
Companies That Report Earnings Companies That Report Earnings without Deduction for Depletion: after Deduction for Depletion:
Alaska Juneau Gold Mining Co. Cerro de Pasco Copper Corp.
Anaconda Copper Mining Co. Granby Consolidated Mining, etc., Co. (copper) Dome Mines, Ltd. (gold) Homestake Mining Co. (gold)
Kennecott Copper Corp. International Nickel Co. of Canada, Ltd. Noranda Mines, Ltd. (copper and gold) Patino Mines, etc. (tin)
Texas Gulf Sulphur Co. Phelps Dodge Corp. (copper) St. Joseph Lead Co.
Depletion and Similar Charges in the Oil Industry. In the oil industry depletion charges are more closely related to the actual cost of doing business than in the case of mining enterprises. The latter ordinar- ily invest in a single property or group of properties, the cost of which is then written off over a fairly long period of years. But the typical large oil producer normally spends substantial sums each year on new leases and new wells. These additional holdings are needed to make up for the shrinkage of reserves through production. The depletion charge corre- sponds in some measure, therefore, to a current cash outlay for the pur- pose of maintaining reserves and production. New wells may yield as high as 80% of their total output during the first year. Hence nearly all the cost of such “ |
er a fairly long period of years. But the typical large oil producer normally spends substantial sums each year on new leases and new wells. These additional holdings are needed to make up for the shrinkage of reserves through production. The depletion charge corre- sponds in some measure, therefore, to a current cash outlay for the pur- pose of maintaining reserves and production. New wells may yield as high as 80% of their total output during the first year. Hence nearly all the cost of such “flush production” must be written off in a single fiscal period, and most of the “earnings” from this source are in reality a return of the capital expended thereon. If the investment is not written off rapidly through depletion and other charges, the profit and the value of the prop- erty account will both be grossly overstated. In the case of an oil company actively engaged in development work, the various headings under which write-offs must be made include the following:
1. Depreciation of tangible assets.
2. Depletion of oil and gas reserves, based upon the cost of the leases.
3. Unprofitable leases written off. Part of the acquisitions and explo- ration will always prove totally valueless and must be charged against the revenue from the productive leases.
4. Intangible drilling costs. These are either written off at one time, as equivalent to an operating expense, or amortized over the life of the well. Example: The case of Marland Oil in 1926 illustrates the extent to which reported earnings of oil companies are dependent upon the accounting policies with respect to amortization. This company spent large sums annually on new leases and wells to maintain its rate of pro- duction. Prior to 1926 it charged the so-called “intangible drilling costs” to capital account and then wrote them off against earnings through an annual amortization charge. In 1926 Marland adopted the more conser- vative policy of charging off all these “intangible costs” currently against
earnings. |
ported earnings of oil companies are dependent upon the accounting policies with respect to amortization. This company spent large sums annually on new leases and wells to maintain its rate of pro- duction. Prior to 1926 it charged the so-called “intangible drilling costs” to capital account and then wrote them off against earnings through an annual amortization charge. In 1926 Marland adopted the more conser- vative policy of charging off all these “intangible costs” currently against
earnings. The effect on profits is shown in the following table.
MARLAND OIL COMPANY
Item 1925 1926 1927
Gross earnings and miscellaneous income $73,231,000 $87,360,000 $58,980,000
Net before reserves 24,495,000 30,303,000 9,808,000
Amortization charges 9,696,000 18,612,000 17,499,000
Balance for stock 14,799,000 11,691,000 7,691,000(d)
In the past ten years significant changes have occurred in the policies followed by the important oil companies. Prior to the depression the gen- eral tendency was towards charging the “intangible drilling costs” to earn- ings—as shown in the change made by Marland in 1926. But since the depression many of the large companies have switched over to the less con- servative basis of capitalizing these costs, subject to annual amortization.10 This change seems justified in good part by the wide adoption of state pro- ration laws, which effectively spread out the total production of a new well over many years instead of concentrating it within a relatively few months. This makes an oil well a fairly long-term capital asset, so that charging off a good part of its cost (now often running to very high figures) against a single year’s profits would be unduly severe.
The companies have also aided their earnings by large write-downs of fixed assets, with corresponding reductions in the annual amortization
10 Companies making this change since 1930 include Standard Oil of Indiana and New Jersey, Gulf Oil, Tidewater Associated, Consolidated Oil.
charges agai |
ths. This makes an oil well a fairly long-term capital asset, so that charging off a good part of its cost (now often running to very high figures) against a single year’s profits would be unduly severe.
The companies have also aided their earnings by large write-downs of fixed assets, with corresponding reductions in the annual amortization
10 Companies making this change since 1930 include Standard Oil of Indiana and New Jersey, Gulf Oil, Tidewater Associated, Consolidated Oil.
charges against them. This practice has perhaps been more widespread among oil companies than in any other industrial group. Some produc- ers have also switched their charges for property retirements from earn- ings to the depreciation reserve. Finally, we have examples of a reduction in amortization charge being brought about by adoption of an “over-all basis” instead of a lease basis for depletion. By this means, oil produced from high-cost leases is written off not at its actual cost but at the aver- age cost of all the oil reserves owned.
The significance of these changes in accounting policy is illustrated by the following:11
Examples: Gulf Oil Corporation increased its 1932 earnings by
$3,621,000, by capitalizing intangible drilling costs instead of charging them off, as formerly.
Socony-Vacuum increased its 1932 earnings by $6,095,000 (and sub- sequent earnings correspondingly) as a result of a write-down of fixed assets with consequent reduction in depreciation charges. In 1935 its prof- its were increased $1,376,000 by charging this sum—representing losses on certain retired property—to depreciation reserve instead of to income, as theretofore. In 1936 it began to capitalize intangible drilling costs, adding about $8,850,000 to profits in that year through this change. In 1937 the company made a further revision in its depreciation policy (apparently intended to place it on the standard basis), which added some
$2,500,000 to that year’s profits.
Pure Oil Company reduced its 1934 |
ts were increased $1,376,000 by charging this sum—representing losses on certain retired property—to depreciation reserve instead of to income, as theretofore. In 1936 it began to capitalize intangible drilling costs, adding about $8,850,000 to profits in that year through this change. In 1937 the company made a further revision in its depreciation policy (apparently intended to place it on the standard basis), which added some
$2,500,000 to that year’s profits.
Pure Oil Company reduced its 1934 depletion charges and increased its earnings by $1,698,000 through adoption of the “over-all” basis.
The Meaning of These Variations to the Analyst and the Investor. These differences of accounting methods are highly confus- ing and may arouse some resentment in the investor. We must recognize, however, that most of them are technically admissible, in that they rep- resent choices between the ordinary and the more conservative basis of amortizing the fixed assets. What is called for, in consequence, is not so much censure as sound interpretation.
Suggested Standards. The analyst should seek to apply a uniform and reasonably conservative rate of amortization to a property base that
11 These examples are drawn largely from Alfred Braunthal, “Are Oil Earnings Reports Fictitious?” Barron’s, Mar. 8, 1937.
reflects the realities of the proposed investment. We suggest the follow- ing standards, in so far as it may be feasible to apply them:
1. Depreciation on Tangible Assets. This should always be taken at the well-established rates, applied to cost—or to a figure substantially less than cost only if the facts clearly justify the write-down.
2. Intangible Drilling Costs. We believe that capitalizing these costs, and then writing them off as oil is produced—although less “conserva- tive”—is the preferable basis both for comparative purposes and to sup- ply a fair reflection of current earnings. In comparing companies that use one and the other method, the analyst must make the be |
always be taken at the well-established rates, applied to cost—or to a figure substantially less than cost only if the facts clearly justify the write-down.
2. Intangible Drilling Costs. We believe that capitalizing these costs, and then writing them off as oil is produced—although less “conserva- tive”—is the preferable basis both for comparative purposes and to sup- ply a fair reflection of current earnings. In comparing companies that use one and the other method, the analyst must make the best allowance he can for the understatement of earnings by the companies that charge off 100% the first year.
Example: The difficulty of making this adjustment in practice may be shown by comparing the 1938 reports of Continental Oil Company and Ohio Oil Company. These two concerns are roughly similar in their set-up. Both produced about 20 million barrels in 1938; Conti- nental Oil refined about two-thirds, and Ohio Oil about one-third its output. Continental charges all its intangible drilling costs direct to income, while Ohio capitalizes these costs and writes them off over the life of the wells.
It might be expected that the total amortization charges of Continen- tal, including drilling expense on the 100% basis, would be relatively higher than those of Ohio. Yet in 1938 Ohio charged off $11,602,000, or 211/2% of its $54 million sales; while Continental charged off $14,038,000, or 17.6% of its $80 million gross. Apparently no adjustment would be needed by the analyst to equalize the two accounting methods. The rea- sons may be found in several circumstances; e.g., (a) after a number of years the gradual write-off method approximates the 100% method, since amortization of old drilling expense becomes continuously greater. (b) In the case of Continental, this concern wrote down its property account in 1932 by some $45,000,000 and thus reduced its normal depreciation and depletion charges considerably in succeeding years.
3. Property Retirement and Abandoned Leases. We thin |
he two accounting methods. The rea- sons may be found in several circumstances; e.g., (a) after a number of years the gradual write-off method approximates the 100% method, since amortization of old drilling expense becomes continuously greater. (b) In the case of Continental, this concern wrote down its property account in 1932 by some $45,000,000 and thus reduced its normal depreciation and depletion charges considerably in succeeding years.
3. Property Retirement and Abandoned Leases. We think that loss on property retired (in excess of depreciation already accrued) should be charged against the year’s earnings, rather than against surplus as is done by most companies in other fields. The reason is that property retirements are likely to be a normal and recurrent factor in the business of a large,
integrated oil company, instead of happening only sporadically as in other lines. Abandoned leases come under this general heading, and the loss thereon should be charged to earnings.
4. Depletion of Oil Reserves. The proper theoretical principle here is that the analyst should allow for depletion on the basis at which the oil reserves are valued in the market. This point, as applied to amortization generally, will be discussed in the next chapter. It implies, as we shall see, that what may be the correct accounting basis for computing depletion may not be the most suitable basis for the analysis of investment values. Unfortunately, business practice in the oil industry has been such as to make the sound application of this principle exceedingly difficult. The oil- producing part of the industry has apparently accounted for most of the profits; the refining and marketing divisions have earned little, if anything, on their investment. If earnings were the criterion of value here, most of the market price of a typical oil stock would be ascribable to the produc- ing division, and on this basis a comparatively high depletion charge against each barrel taken out would be |
n such as to make the sound application of this principle exceedingly difficult. The oil- producing part of the industry has apparently accounted for most of the profits; the refining and marketing divisions have earned little, if anything, on their investment. If earnings were the criterion of value here, most of the market price of a typical oil stock would be ascribable to the produc- ing division, and on this basis a comparatively high depletion charge against each barrel taken out would be called for. On the other hand, if the division were made in proportion to book values, the refining and market- ing sections would loom large, the oil reserves would have a much smaller
value, and the depletion charge would be proportionately smaller.
We do not see any really satisfactory answer to the dilemma that we have posed—for it seems to us that the partition of earning power in the industry between production and the other branches is an essentially arti- ficial one and cannot be viewed as permanent. We therefore are led to suggest the following practical compromise with the problem:
1. In the case of integrated oil companies, accept the company’s deple- tion figure as the best available. (This includes acceptance of the “over- all” basis, if used, since this method would seem to reflect the facts fairly.) However, any charges for depletion made against an “appreciation” account in the balance sheet should be deducted from income.
2. In the case of companies that are solely oil producers, or virtually so, the analyst can compute what the market is paying for the total devel- oped oil reserves (if an estimate of these is published). Hence he can make his own depletion calculation, for the particular purpose of his analysis, in such an instance in the same manner as in the case of a mining propo- sition. (For a calculation of this kind applied to Texas Gulf Producing Company see p. 502 on accompanying CD.)
OTHER TYPES OF AMORTIZATION
OF CAPITAL ASSETS
Leaseholds and |
producers, or virtually so, the analyst can compute what the market is paying for the total devel- oped oil reserves (if an estimate of these is published). Hence he can make his own depletion calculation, for the particular purpose of his analysis, in such an instance in the same manner as in the case of a mining propo- sition. (For a calculation of this kind applied to Texas Gulf Producing Company see p. 502 on accompanying CD.)
OTHER TYPES OF AMORTIZATION
OF CAPITAL ASSETS
Leaseholds and Leasehold Improvements. The ordinary lease involves no capital investment by the lessee, who merely undertakes to pay rent in return for the use of property. But if the rental payments are considerably less than the use of the property is worth, and if the arrange- ment has a considerable period to run, the leasehold—as it is called—may have a substantial value. Oil lands are leased on a standard basis for a roy- alty amounting usually to one-eighth of the production. Leaseholds on which a substantial output is developed or assured are worth a large bonus above the rental payments involved, and they are bought and sold in the same way as the fee ownership of the property. Similar bonuses are paid—in boom times usually—for long-term leases on urban real estate.
If a company has paid money for a leasehold, the cost is regarded as a capital investment that should be written off during the life of the lease. (In the case of an oil lease the write-off is made against each barrel pro- duced, rather than on a time basis, since the output declines rapidly from the initial flush figure.) These charges are in reality part of the rent paid for the property and must obviously be included in current operating expense. When structures are built on leased property or alterations made or fixtures installed, they are designated as “leasehold improvements.” Hence their cost must be written down to nothing during the life of the lease, since they belong to the landlord when the lease expires. |
, rather than on a time basis, since the output declines rapidly from the initial flush figure.) These charges are in reality part of the rent paid for the property and must obviously be included in current operating expense. When structures are built on leased property or alterations made or fixtures installed, they are designated as “leasehold improvements.” Hence their cost must be written down to nothing during the life of the lease, since they belong to the landlord when the lease expires. The annual charge-off for this purpose is called “amortization of leasehold improve- ments.” It partakes to some extent of the nature of a depreciation charge. Chain-store enterprises frequently invest considerable sums in such lease- hold improvements, and consequently the annual write-offs thereof may
be of appreciable importance in their income accounts.
Example: The December 31, 1938, balance sheet of F.W. Woolworth Company carried “Buildings Owned and Improvements on Leased Premises to be amortized over periods of leases” at a net valuation of
$46,717,000. The charge against 1938 earnings for amortization of these buildings and leasehold improvements amounted to $3,925,283.
Since these items belong to the amortization group, they lend them- selves to the same kind of arbitrary treatment as do the others. By mak- ing the annual charge against surplus instead of income or by writing
down the entire capital investment to $1 and thus eliminating the annual charge entirely, a corporation can exclude these items of operating cost from its reported per-share earnings and thus make the latter appear deceptively large.
Amortization of Patents. In theory, a patent should be dealt with in exactly the same way as a mining property; i.e., its cost to the investor should be written off against earnings during its remaining life. It is obvi- ous, therefore, that charges made against earnings by the company— which are based on the book value of the patent—have ordinarily little releva |
tion can exclude these items of operating cost from its reported per-share earnings and thus make the latter appear deceptively large.
Amortization of Patents. In theory, a patent should be dealt with in exactly the same way as a mining property; i.e., its cost to the investor should be written off against earnings during its remaining life. It is obvi- ous, therefore, that charges made against earnings by the company— which are based on the book value of the patent—have ordinarily little relevance to the real situation. Consideration of this question belongs chiefly to a later chapter on amortization from the investor’s standpoint, and to avoid dividing our treatment we shall postpone to the same place our brief discussion of the accounting methods relative to patents encountered in corporate reports.
Amortization of Good-will. This is a matter of very minor impor- tance. A few companies have followed the rather extraordinary policy of charging off their good-will account against earnings in a number of annual installments.
Examples: Radio Corporation of America charged $310,000 a year for this purpose between 1934 and 1937. This was applicable to the good- will account of its subsidiary National Broadcasting Company and was discontinued in 1938, although $1,876,000 remained unamortized.
Obviously, this practice has no factual basis, since good-will has no duration of life apart from that of the business as a whole. Where the item is of any size, the analyst should adjust the earnings by canceling the charge.
Chapter 37
SIGNIFICANCE OF THE
EARNINGS RECORD
IN THE LAST SIX CHAPTERS our attention was devoted to a critical examina- tion of the income account for the purpose of arriving at a fair and inform- ing statement of the results for the period covered. The second main question confronting the analyst is concerned with the utility of this past record as an indicator of future earnings. This is at once the most important and the least satisfactory asp |
e earnings by canceling the charge.
Chapter 37
SIGNIFICANCE OF THE
EARNINGS RECORD
IN THE LAST SIX CHAPTERS our attention was devoted to a critical examina- tion of the income account for the purpose of arriving at a fair and inform- ing statement of the results for the period covered. The second main question confronting the analyst is concerned with the utility of this past record as an indicator of future earnings. This is at once the most important and the least satisfactory aspect of security analysis. It is the most important because the sole practical value of our laborious study of the past lies in the clue it may offer to the future; it is the least satisfactory because this clue is never thoroughly reliable and it frequently turns out to be quite valueless. These shortcomings detract seriously from the value of the analyst’s work, but they do not destroy it. The past exhibit remains a sufficiently depend- able guide, in a sufficient proportion of cases, to warrant its continued use as the chief point of departure in the valuation and selection of securities.
The Concept of Earning Power. The concept of earning power has a definite and important place in investment theory. It combines a statement of actual earnings, shown over a period of years, with a reasonable expecta- tion that these will be approximated in the future, unless extraordinary con- ditions supervene. The record must cover a number of years, first because a continued or repeated performance is always more impressive than a single occurrence and secondly because the average of a fairly long period will tend to absorb and equalize the distorting influences of the business cycle.
A distinction must be drawn, however, between an average that is the mere arithmetical resultant of an assortment of disconnected figures and an average that is “normal” or “modal,” in the sense that the annual results show a definite tendency to approximate the average. The contrast between one type of ea |
ce is always more impressive than a single occurrence and secondly because the average of a fairly long period will tend to absorb and equalize the distorting influences of the business cycle.
A distinction must be drawn, however, between an average that is the mere arithmetical resultant of an assortment of disconnected figures and an average that is “normal” or “modal,” in the sense that the annual results show a definite tendency to approximate the average. The contrast between one type of earning power and the other may be clearer from the following examples:
[472]
Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use.
ADJUSTED EARNINGS PER SHARE 1923–1932
Year S. H. Kress Hudson Motors
1932 $2.80 $3.54(d)
1931 4.19 1.25(d)
1930 4.49 0.20
1929 5.92 7.26
1928 5.76 8.43
1927 5.26 9.04
1926 4.65 3.37
1925 4.12 13.39
1924 3.06 5.09
1923 3.39 5.56
10-year average $4.36 $ 4.75
The average earnings of about $4.50 per share shown by S. H. Kress and Company can truly be called its “indicated earning power,” for the reason that the figures of each separate year show only moderate variations from this norm. On the other hand the Hudson Motors average of $4.75 per share is merely an abstraction from ten widely varying figures, and there was no convincing reason to believe that the earnings from 1933 onward would bear a recognizable relationship to this average. A similar conclusion was drawn from our discussion of the exhibit of J. I. Case Company on page 65.
These conclusions, reached in 1933, are supported by the results of the six years following:
EARNINGS PER SHARE
Year S. H. Kress1 Hudson Motors J. I. Case
1933 $4.23 $2.87(d) $14.66(d)
1934 4.76 2.10(d) 7.38(d)
1935 4.63 0.38 5.70
1936 4.62 2.14 12.37
1937 4.62 0.42 19.20
1938 2.76 2.94(d) 8.89
1939 3.86 0.86(d) 1.87(d)
1 Stated on basis of old capitalization, before 2-for-1 split-up in 1936.
Quantitative Analysis Should Be Supplemented by Qualitative Con |
it of J. I. Case Company on page 65.
These conclusions, reached in 1933, are supported by the results of the six years following:
EARNINGS PER SHARE
Year S. H. Kress1 Hudson Motors J. I. Case
1933 $4.23 $2.87(d) $14.66(d)
1934 4.76 2.10(d) 7.38(d)
1935 4.63 0.38 5.70
1936 4.62 2.14 12.37
1937 4.62 0.42 19.20
1938 2.76 2.94(d) 8.89
1939 3.86 0.86(d) 1.87(d)
1 Stated on basis of old capitalization, before 2-for-1 split-up in 1936.
Quantitative Analysis Should Be Supplemented by Qualitative Considerations. In studying earnings records an important principle of security analysis must be borne in mind:
Quantitative data are useful only to the extent that they are supported by a qualitative survey of the enterprise.
In order for a company’s business to be regarded as reasonably stable, it does not suffice that the past record should show stability. The nature of the undertaking, considered apart from any figures, must be such as to indicate an inherent permanence of earning power. The importance of this additional criterion was well illustrated by the case of the Studebaker Cor- poration which was used as an example in our discussion of qualitative factors in analysis on page 87. It is possible, on the other hand, that there may be considerable variation in yearly earnings, but there is a reasonable basis nevertheless for taking the average as a rough index at least of future performance. In 1934 we cited United States Steel Corporation as a lead- ing case in point. The text of our discussion was as follows:
The annual earnings for 1923–1932 are given below.
UNITED STATES STEEL CORPORATION, 1923–1932
Year Earnings per share of common* Output of finished steel, tons % of total output
of country Net per ton before deprec.
1932 $11.08(d) 3,591,000 34.4 $3.54(d)
1931 1.40(d) 7,196,000 37.5 5.71
1930 9.12 11,609,000 39.3 13.10
1929 21.19 15,303,000 37.3 16.90
1928 12.50 13,972,000 37.1 13.83
1927 8.81 12,979,000 39.5 12.66
1926 12.85 14,334,000 40.4 13.89
1925 9.19 13 |
our discussion was as follows:
The annual earnings for 1923–1932 are given below.
UNITED STATES STEEL CORPORATION, 1923–1932
Year Earnings per share of common* Output of finished steel, tons % of total output
of country Net per ton before deprec.
1932 $11.08(d) 3,591,000 34.4 $3.54(d)
1931 1.40(d) 7,196,000 37.5 5.71
1930 9.12 11,609,000 39.3 13.10
1929 21.19 15,303,000 37.3 16.90
1928 12.50 13,972,000 37.1 13.83
1927 8.81 12,979,000 39.5 12.66
1926 12.85 14,334,000 40.4 13.89
1925 9.19 13,271,000 39.7 12.49
1924 8.41 11,723,000 41.7 13.05
1923 11.73 14,721,000 44.2 12.20
10-year average $ 8.13 11,870,000 39.1 11.03
* Adjusted for changes in capitalization.
If compared with those of Studebaker for 1920–1929, the foregoing earnings show much greater instability. Yet the average of about $8 per share for the ten-year period has far more significance as a guide to the future than had Studebaker’s indicated earning power of about $6.75 per share. This greater dependability arises from the entrenched position of United States Steel in its industry; and also from the relatively narrow fluctuations in both the annual output and the profit per ton over most of this period. These two elements may be used as a basis for calculating approximate “normal earnings” of U. S. Steel, somewhat as follows:
Normal or usual annual production of finished goods . . . . . . . . . . . 13,000,000 tons
Gross receipts per ton of finished products . . . . . . . . . . . . . . . . . . . . . $100.00
Net earnings per ton before depreciation . . . . . . . . . . . . . . . . . . . . . . . $12.50
Net earnings on 13,000,000 tons . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $160,000,000.00
Depreciation, bond interest, and preferred dividends . . . . . . . . . . . . 90,000,000.00
Balance for 8,700,000 shares of common . . . . . . . . . . . . . . . . . . . . . . . 70,000,000.00
Normal earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $8.00
The |
0
Net earnings per ton before depreciation . . . . . . . . . . . . . . . . . . . . . . . $12.50
Net earnings on 13,000,000 tons . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $160,000,000.00
Depreciation, bond interest, and preferred dividends . . . . . . . . . . . . 90,000,000.00
Balance for 8,700,000 shares of common . . . . . . . . . . . . . . . . . . . . . . . 70,000,000.00
Normal earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $8.00
The average earnings for the 1923–1932 decade are thus seen to approximate a theoretical figure based upon a fairly well-defined “nor- mal” output and profit margin. (The increase in number of shares out- standing prevents this normal figure from exceeding the ten-year average.) Although a substantial margin of error must be allowed for in such a computation, it at least supplies a starting point for an intelligent estimate of future probabilities.
Examining this analysis six years later, we may draw some conflicting conclusions as to its value. United States Steel’s earnings did recover to $7.88 per share in 1937 ($8.31 before the surtax on undistributed profits). The price advanced from the 1933 average of 451/2 to a high of 126 in March 1937. Hence our implication that the company had a better earning power than the 1932 results and stock prices reflected would seem to have been amply justified by the event.
But actually the average earnings for 1934–1939 have been quite dis- appointing (amounting to no more than 14 cents per share). If these results have as much validity for the steel industry as they have for most lines of business, we should have to admit that the analysis based on 1923–1932 was not really useful, because the underlying conditions in steel have changed for the worse. (The change consists chiefly in much
higher unit costs and a lower average output, selling prices on the whole having been well maintained.1)
Current Earnings Should Not Be the Primary Basis |
(amounting to no more than 14 cents per share). If these results have as much validity for the steel industry as they have for most lines of business, we should have to admit that the analysis based on 1923–1932 was not really useful, because the underlying conditions in steel have changed for the worse. (The change consists chiefly in much
higher unit costs and a lower average output, selling prices on the whole having been well maintained.1)
Current Earnings Should Not Be the Primary Basis of Appraisal. The market level of common stocks is governed more by their current earnings than by their long-term average. This fact accounts in good part for the wide fluctuations in common-stock prices, which largely (though by no means invariably) parallel the changes in their earn- ings between good years and bad. Obviously the stock market is quite irrational in thus varying its valuation of a company proportionately with
the temporary changes in its reported profits.2 A private business might easily earn twice as much in a boom year as in poor times, but its owner would never think of correspondingly marking up or down the value of his capital investment.
This is one of the most important lines of cleavage between Wall Street practice and the canons of ordinary business. Because the speculative public is clearly wrong in its attitude on this point, it would seem that its errors should afford profitable opportunities to the more logically minded to buy common stocks at the low prices occasioned by temporarily reduced earnings and to sell them at inflated levels created by abnormal prosperity.
The Classical Formula for “Beating the Stock Market.” We have here the long-accepted and classical formula for “beating the stock market.” Obviously it requires strength of character in order to think and to act in opposite fashion from the crowd and also patience to wait for opportu- nities that may be spaced years apart. But there are still other considera- tions that greatly com |
ices occasioned by temporarily reduced earnings and to sell them at inflated levels created by abnormal prosperity.
The Classical Formula for “Beating the Stock Market.” We have here the long-accepted and classical formula for “beating the stock market.” Obviously it requires strength of character in order to think and to act in opposite fashion from the crowd and also patience to wait for opportu- nities that may be spaced years apart. But there are still other considera- tions that greatly complicate this apparently simple rule for successful
1 It may be interesting to note that our 1933 conclusions as to the earning power of United States Steel are quite similar to those reached by J. B. Williams in his elaborate study of this company contained in his book The Theory of Investment Value, pp. 409–462. But note also, as against the foregoing indication of normal earning power, the rather pessimistic implica- tions of the longer range study of United States Steel’s position on pp. 607–611 below. The company’s failure to reestablish this earning power in 1934–1939 might suggest that the lat- ter analysis deserved the greater weight.
2 The rise of United States Steel to 126 in March 1937, already mentioned, is a striking exam- ple of this folly of the stock market. It was based on a single good year, following six bad or mediocre ones. Within twelve months the price had declined to 42—a loss of two-thirds of its quotation, and over $730,000,000 in aggregate market value for this single issue. The range of Youngstown Sheet and Tube and Jones and Laughlin Steel in that period was even wider.
operations in stocks. In actual practice the selection of suitable buying and selling levels becomes a difficult matter. Taking the long market cycle of 1921–1933, an investor might well have sold out at the end of 1925 and remained out of the market in 1926–1930 and bought again in the depres- sion year 1931. The first of these moves would later have seemed a bad mistake of judg |
is single issue. The range of Youngstown Sheet and Tube and Jones and Laughlin Steel in that period was even wider.
operations in stocks. In actual practice the selection of suitable buying and selling levels becomes a difficult matter. Taking the long market cycle of 1921–1933, an investor might well have sold out at the end of 1925 and remained out of the market in 1926–1930 and bought again in the depres- sion year 1931. The first of these moves would later have seemed a bad mistake of judgment, and the last would have had most disturbing con- sequences. In other market cycles of lesser amplitude such serious mis- calculations are not so likely to occur, but there is always a good deal of doubt with regard to the correct time for applying the simple principle of “buy low and sell high.”
It is true also that underlying values may change substantially from one market cycle to another, more so, of course, in the case of individual issues than for the market as a whole. Hence if a common stock is sold at what seems to be a generous price in relation to the average of past earn- ings, it may later so improve its position as to justify a still higher quota- tion even in the next depression. The converse may occur in the purchase of securities at subnormal prices. If such permanent changes did not fre- quently develop, it is doubtful if the market would respond so vigorously to current variations in the business picture. The mistake of the market lies in its assumption that in every case changes of this sort are likely to go farther, or at least to persist, whereas experience shows that such devel- opments are exceptional and that the probabilities favor a swing of the pendulum in the opposite direction.
The analyst cannot follow the stock market in its indiscriminate tendency to value issues on the basis of current earnings. He may on occa- sion attach predominant weight to the recent figures rather than to the average, but only when persuasive evidence is at hand po |
every case changes of this sort are likely to go farther, or at least to persist, whereas experience shows that such devel- opments are exceptional and that the probabilities favor a swing of the pendulum in the opposite direction.
The analyst cannot follow the stock market in its indiscriminate tendency to value issues on the basis of current earnings. He may on occa- sion attach predominant weight to the recent figures rather than to the average, but only when persuasive evidence is at hand pointing to the continuance of these current results.
Average vs. Trend of Earnings. In addition to emphasizing strongly the current showing of a company, the stock market attaches great weight to the indicated trend of earnings. In Chap. 27 we pointed out the twofold danger inhering in this magnification of the trend—the first being that the supposed trend might prove deceptive, and the second being that valua- tions based upon trend obey no arithmetical rules and therefore may too easily be exaggerated. There is indeed a fundamental conflict between the concepts of the average and of the trend, as applied to an earnings record. This may be illustrated by the following simplified example:
Company Earned per share in successive years
1st
2nd
3d
4th
5th
6th 7th (current) Average of 7 years
Trend
A $ 1 $ 2 $ 3 $ 4 $5 $6 $7 $ 4 Excellent
B 7 7 7 7 7 7 7 7 Neutral
C 13 12 11 10 9 8 7 10 Bad
On the basis of these figures the better the trend, when compared with the same current earnings (in this case $7 per share), the poorer the aver- age and the higher the average the poorer the trend. They suggest an important question respecting the theoretical and practical interpretation of earnings records: Is not the trend at least as significant for the future as the average? Concretely, in judging the probable performance of Compa- nies A and C over the next five years, would not there be more reason to think in terms of a sequence of $8, $9, $10, $11, and $12 for A and a s |
t earnings (in this case $7 per share), the poorer the aver- age and the higher the average the poorer the trend. They suggest an important question respecting the theoretical and practical interpretation of earnings records: Is not the trend at least as significant for the future as the average? Concretely, in judging the probable performance of Compa- nies A and C over the next five years, would not there be more reason to think in terms of a sequence of $8, $9, $10, $11, and $12 for A and a sequence of $7, $6, $5, $4, and $3 for C rather than in terms of the past average of $4 for A and $10 for C?
The answer to this problem derives from common sense rather than from formal or a priori logic. The favorable trend of Company A’s results must certainly be taken into account, but not by a mere automatic projec- tion of the line of growth into the distant future. On the contrary, it must be remembered that the automatic or normal economic forces militate against the indefinite continuance of a given trend.3 Competition, regula- tion, the law of diminishing returns, etc., are powerful foes to unlimited expansion, and in smaller degree opposite elements may operate to check a continued decline. Hence instead of taking the maintenance of a favor- able trend for granted—as the stock market is wont to do—the analyst must approach the matter with caution, seeking to determine the causes of the superior showing and to weigh the specific elements of strength in the company’s position against the general obstacles in the way of contin- ued growth.
Attitude of Analyst Where Trend Is Upward. If such a qualitative study leads to a favorable verdict—as frequently it should—the analyst’s philos- ophy must still impel him to base his investment valuation on an assumed earning power no larger than the company has already achieved in a
3 See our discussion of the Schletter and Zander example in Chap. 27.
period of normal business. This is suggested because, in our opinion, investmen |
ainst the general obstacles in the way of contin- ued growth.
Attitude of Analyst Where Trend Is Upward. If such a qualitative study leads to a favorable verdict—as frequently it should—the analyst’s philos- ophy must still impel him to base his investment valuation on an assumed earning power no larger than the company has already achieved in a
3 See our discussion of the Schletter and Zander example in Chap. 27.
period of normal business. This is suggested because, in our opinion, investment values can be related only to demonstrated performance; so that neither expected increases nor even past results under conditions of abnormal business activity may be taken as a basis. As we shall point out in the next chapter, this assumed earning power may properly be capital- ized more liberally when the prospects appear excellent than in the ordi- nary case, but we shall also suggest that the maximum multiplier be held to a conservative figure (say, 20, under the conditions of 1940) if the val- uation reached is to be kept within strictly investment limits. On this basis, assuming that general business conditions in the current year are not unusually good, the earning power of Company A might be taken at
$7 per share, and its investment value might be set as high as 140.4 The divergence in method between the stock market and the analyst—as we define his viewpoint—would mean in general that the price levels ruling for the so-called “good stocks” under normal market conditions are likely to appear overgenerous to the conservative student. This does not mean that the analyst is convinced that the market valuation is wrong but rather that he is not convinced that its valuation is right. He would call a sub- stantial part of the price a “speculative component,” in the sense that it is paid not for demonstrated but for expected results. (This subject is discussed further in Chap. 39.)
Attitude of Analyst Where Trend Is Downward. Where the trend has been definitely downward, a |
likely to appear overgenerous to the conservative student. This does not mean that the analyst is convinced that the market valuation is wrong but rather that he is not convinced that its valuation is right. He would call a sub- stantial part of the price a “speculative component,” in the sense that it is paid not for demonstrated but for expected results. (This subject is discussed further in Chap. 39.)
Attitude of Analyst Where Trend Is Downward. Where the trend has been definitely downward, as that of Company C, the analyst will assign great weight to this unfavorable factor. He will not assume that the down- curve must presently turn upward, nor can he accept the past average— which is much higher than the current figure—as a normal index of future earnings. But he will be equally chary about any hasty conclusions to the effect that the company’s outlook is hopeless, that its earnings are certain to disappear entirely and that the stock is therefore without merit or value. Here again a qualitative study of the company’s situation and prospects is essen- tial to forming an opinion whether at some price, relatively low, of course, the issue may not be a bargain, despite its declining earnings trend. Once more we identify the viewpoint of the analyst with that of a sensible busi- ness man looking into the pros and cons of some privately owned enterprise.
4 See Appendix Note 53, p. 790 on accompanying CD, for a reference to the more conserva- tive viewpoint on this matter expressed by us in the 1934 edition of this work and the rea- sons for the change.
To illustrate this reasoning, we append the record of net earnings for 1925–1933 of Continental Baking Corporation and American Laundry Machinery Company.
Year Continental Baking American Laundry Machinery
1933 $2,788,000 $1,187,000(d)
1932 2,759,000 986,000(d)
1931 4,243,000 772,000
1930 6,114,000 1,849,000
1929 6,671,000 3,542,000
1928 5,273,000 4,128,000
1927 5,570,000 4,221,000
1926 6,547,000 4,807,000
1925 |
pressed by us in the 1934 edition of this work and the rea- sons for the change.
To illustrate this reasoning, we append the record of net earnings for 1925–1933 of Continental Baking Corporation and American Laundry Machinery Company.
Year Continental Baking American Laundry Machinery
1933 $2,788,000 $1,187,000(d)
1932 2,759,000 986,000(d)
1931 4,243,000 772,000
1930 6,114,000 1,849,000
1929 6,671,000 3,542,000
1928 5,273,000 4,128,000
1927 5,570,000 4,221,000
1926 6,547,000 4,807,000
1925 8,794,000 5,101,000
The profits of American Laundry Machinery reveal an uninterrupted decline, and the trend shown by Continental Baking is almost as bad. It will be noted that in 1929—the peak of prosperity for most companies— the profits of these concerns were substantially less than they were four years earlier.
Wall Street reasoning would be prone to conclude from this exhibit that both enterprises are definitely on the downward path. But such extreme pessimism would be far from logical. A study of these two busi- nesses from the qualitative standpoint would indicate first that the respec- tive industries are permanent and reasonably stable and secondly that each company occupies a leading position in its industry and is well for- tified financially. The inference would properly follow that the unfavor- able tendency shown during 1925–1932 was probably due to accidental or nonpermanent conditions and that in gaging the future earning power more enlightenment will be derived from the substantial average than from the seemingly disastrous trend.5
Deficits a Qualitative, Not a Quantitative Factor. When a com- pany reports a deficit for the year, it is customary to calculate the amount in dollars per share or in relation to interest requirements. The statistical
5 The results since 1933 would tend to bear out this earlier conclusion, at least in part.
manuals will state, for example, that in 1932 United States Steel Corpo- ration earned its bond-interest “deficit 12.40 tim |
e substantial average than from the seemingly disastrous trend.5
Deficits a Qualitative, Not a Quantitative Factor. When a com- pany reports a deficit for the year, it is customary to calculate the amount in dollars per share or in relation to interest requirements. The statistical
5 The results since 1933 would tend to bear out this earlier conclusion, at least in part.
manuals will state, for example, that in 1932 United States Steel Corpo- ration earned its bond-interest “deficit 12.40 times” and that it showed a deficit of $11.08 per share on its common stock. It should be recognized that such figures, when taken by themselves, have no quantitative signif- icance and that their value in forming an average may often be open to serious question.
Let us assume that Company A lost $5 per share of common in the last year and Company B lost $7 per share. Both issues sell at 25. Is this an indication of any sort that Company A stock is preferable to Company B stock? Obviously not; for assuming it were so, it would mean that the more shares there were outstanding the more valuable each share would be. If Company B issues 2 shares for 1, the loss would be reduced to $3.50 per share, and on the assumption just made, each new share would then be worth more than an old one. The same reasoning applies to bond interest. Suppose that Company A and Company B each lost $1,000,000 in 1932. Company A has $4,000,000 of 5% bonds and Company B has
$10,000,000 of 5% bonds. Company A would then show interest earned “deficit 5 times” and Company B would earn its interest “deficit 2 times.” These figures should not be construed as an indication of any kind that Company A’s bonds are less secure than Company B’s bonds. For, if so, it would mean that the smaller the bond issue the poorer its position—a manifest absurdity.
When an average is taken over a period that includes a number of deficits, some question must arise as to whether or not the resultant figure is really indicative of t |
en show interest earned “deficit 5 times” and Company B would earn its interest “deficit 2 times.” These figures should not be construed as an indication of any kind that Company A’s bonds are less secure than Company B’s bonds. For, if so, it would mean that the smaller the bond issue the poorer its position—a manifest absurdity.
When an average is taken over a period that includes a number of deficits, some question must arise as to whether or not the resultant figure is really indicative of the earning power. For the wide variation in the indi- vidual figures must detract from the representative character of the aver- age. This point is of considerable importance in view of the prevalence of deficits during the depression of the 1930’s. In the case of most companies the average of the years since 1933 may now be thought more representa- tive of indicated earning power than, say, a ten-year average 1930–1939.6
Intuition Not a Part of the Analyst’s Stock in Trade. In the absence of indications to the contrary we accept the past record as a basis for judging the future. But the analyst must be on the lookout for any such
6 It is an open question whether or not either the ten-year period 1930–1939 or the six years 1934–1939 fairly reflect the future earning power of companies in the heavy industries, e.g., United States Steel, Bethlehem Steel, American Locomotive.
indications to the contrary. Here we must distinguish between vision or intuition on the one hand, and ordinary sound reasoning on the other. The ability to see what is coming is of inestimable value, but it cannot be expected to be part of the analyst’s stock in trade. (If he had it, he could dispense with analysis.) He can be asked to show only that moderate degree of foresight which springs from logic and from experience intel- ligently pondered. It was not to be demanded of the securities statistician, for example, that he foretell the enormous increase in cigarette consump- tion since 1915 or the de |
sound reasoning on the other. The ability to see what is coming is of inestimable value, but it cannot be expected to be part of the analyst’s stock in trade. (If he had it, he could dispense with analysis.) He can be asked to show only that moderate degree of foresight which springs from logic and from experience intel- ligently pondered. It was not to be demanded of the securities statistician, for example, that he foretell the enormous increase in cigarette consump- tion since 1915 or the decline in the cigar business or the astonishing sta- bility of the snuff industry; nor could he have predicted—to use another example—that the two large can companies would be permitted to enjoy the full benefits from the increasing demand for their product, without the intrusion of that demoralizing competition which ruined the profits of even faster growing industries, e.g., radio.
Analysis of the Future Should Be Penetrating Rather than Prophetic. Analytical reasoning with regard to the future is of a somewhat different character, being penetrating rather than prophetic.7
Example: Let us take the situation presented by Intertype Corporation in March-July 1939, when the stock was selling at $8 per share. This old, established company was one of the leaders in a relatively small industry (line-casting machines, etc., for the printing trade). Its recent earnings had not been favorable, nor did there seem to be any particular reason for optimistic expectations as to the near-term outlook. The analyst, how- ever, could not fail to be impressed by the balance sheet, which showed net current assets available for the stock amounting to close to $20 per share. The ten-year earnings, dividend and price record of the common stock was as shown in the table on p. 483.
Certainly there is nothing attractive in this record, marked as it is by irregularity and the absence of a favorable trend. But although these facts would undoubtedly condemn the issue in the eyes of the speculator, the re |
. The analyst, how- ever, could not fail to be impressed by the balance sheet, which showed net current assets available for the stock amounting to close to $20 per share. The ten-year earnings, dividend and price record of the common stock was as shown in the table on p. 483.
Certainly there is nothing attractive in this record, marked as it is by irregularity and the absence of a favorable trend. But although these facts would undoubtedly condemn the issue in the eyes of the speculator, the reasoning of the analyst might conceivably run along different lines.
The essential question for him would be whether or not the company can be counted on to remain in business and to participate about as before in good times and bad. On this point consideration of the industry, the
7 See Appendix Note 54, p. 790 on accompanying CD, for an example (Mack Trucks, Inc.) used in the first edition of this work, together with its sequel.
Year Earned per share Dividend paid Price range
1938 $0.57 0.45 123/4–8
1937 1.41 0.80 261/2–9
1936 1.42 0.75 223/4–15
1935 0.75 0.40 16–61/8
1934 0.21 10–55/8
1933 0.77(d) 111/4–17/8
1932 1.82(d) 7–21/2
1931 0.56 1.00 181/2–45/8
1930 1.46 2.00 32–12
1929 3.05 1.75 387/8–17
Average 1934–1938 0.87
Average 1929–1938 0.68
company’s prominent position in it and the strong financial set-up would clearly suggest an affirmative answer. If this were granted, the analyst would then point out that the shares could be bought at 8 with very small chance of ultimate loss and with every indication that under the next set of favorable conditions the value of the stock would double. Note that in 3 years out of the past 5 and in 6 out of the past 10, the stock sold between 2 and 4 times the July 1939 price.
This type of reasoning, it will be noted, lays emphasis not upon an accu- rate prediction of future trends but rather on reaching the general conclu- sion that the company will continue to do business pretty much as before. Wall Street is inclined to do |
mate loss and with every indication that under the next set of favorable conditions the value of the stock would double. Note that in 3 years out of the past 5 and in 6 out of the past 10, the stock sold between 2 and 4 times the July 1939 price.
This type of reasoning, it will be noted, lays emphasis not upon an accu- rate prediction of future trends but rather on reaching the general conclu- sion that the company will continue to do business pretty much as before. Wall Street is inclined to doubt that any such presumption may be applied to companies with an irregular trend, and to consider that it is just as difficult and hazardous to reach a conclusion of this kind as to determine that a “growing company” will continue to grow. But in our view the Intertype form of reasoning has two definite advantages over the customary attitude, e.g., that which would prefer a company such as Coca-Cola, at 22 times recent earnings and 35 times its asset value, because of the virtually uninterrupted expansion of its profits for more
than 15 years.
The first advantage is that, after all, private business is conducted and investments made therein on the same kind of assumptions that we have made with respect to Intertype. The second is that reasoning of this kind can be conservative in that it allows for a liberal margin of safety in case
of error or disappointment. It runs considerably less risk of confusion between “confidence in the future” and mere speculative enthusiasm.
Large Profits Frequently Transitory. More frequently we have the opposite type of situation from that just discussed. Here the analyst finds reason to question the indefinite continuance of past prosperity.
Examples: Consider a company like J. W. Watson (“Stabilator”) Com- pany, engaged chiefly in the manufacture of a single type of automotive accessory. The success of such a “gadget” is normally short-lived; compe- tition and changes in the art are an ever present threat to the stability of earning power. |
s Frequently Transitory. More frequently we have the opposite type of situation from that just discussed. Here the analyst finds reason to question the indefinite continuance of past prosperity.
Examples: Consider a company like J. W. Watson (“Stabilator”) Com- pany, engaged chiefly in the manufacture of a single type of automotive accessory. The success of such a “gadget” is normally short-lived; compe- tition and changes in the art are an ever present threat to the stability of earning power. Hence in such a case the student could have pointed out that the market price, bearing the usual ratio to current and average earn- ings, reflected a quite unwarranted confidence in the permanence of prof- its that by their nature were likely to be transitory. Some of the pertinent data relative to this judgment are given in the table below, with respect to this company.8
THE J. W. WATSON COMPANY
Year
Net for common
Per share Price range for common
Dividend
1932 $214,026(d) $1.07(d) 3/8–1/8 None
1931 240,149(d) 1.20(d) 2–1/8 None
1930 264,269(d) 1.32(d) 6–1 None
1929 323,137(d) 1.61(d) 147/8–15/8 None
1928 348,930(d) 1.74(d) 20–51/4 50 cents
1927 503,725 2.16 253/4–187/8 50 cents
1926 577,450* 2.88* (Issue not quoted
prior to 1927)
1925 502,593* 2.51*
1924 29,285* 0.15*
1923 173,907* 0.86*
1922 142,701* 0.71*
* Earnings are for predecessor companies, applied to 1932 capitalization.
8 The common stock of the company was originally offered in September 1927 at $24.50 per share, a price 17.3 times the average earnings of the predecessor companies during the pre- ceding five years. This relatively high price was accounted for in part by the apparently
A similar consideration would apply to the exhibit of Coty, Inc., in 1928. Here was a company with an excellent earnings record, but the earn- ings were derived from the popularity of a trade-marked line of cosmet- ics. This was a field in which the variable tastes of femininity could readily destroy profits as |
per share, a price 17.3 times the average earnings of the predecessor companies during the pre- ceding five years. This relatively high price was accounted for in part by the apparently
A similar consideration would apply to the exhibit of Coty, Inc., in 1928. Here was a company with an excellent earnings record, but the earn- ings were derived from the popularity of a trade-marked line of cosmet- ics. This was a field in which the variable tastes of femininity could readily destroy profits as well as build them up. The inference that rapidly rising profits in previous years meant much larger profits in the future was thus especially fallacious in this case, because by the nature of the business a peak of popularity was likely to be reached at some not distant point, after which a substantial falling off would be, if not inevitable, at least highly probable. Some of the data appearing on the Coty exhibit are as follows:
Year
Net income Earned per share (adjusted)
1923 $1,070,000 $0.86
1924 2,046,000 1.66
1925 2,505,000 2.02
1926 2,943,000 2.38
1927 3,341,000 2.70
1928 4,047,000 3.09
1929 4,058,000 2.73
At the high price of 82 in 1929, Coty, Inc., was selling in the market for about $120,000,000, or thirty times its maximum earnings. The actual investment in the business (capital and surplus) amounted to about
$14,000,000.
Subsequent earnings were as shown in the table following.
COTY, INC.
Year Net income Earned per share
1930 $1,318,000 $0.86
1931 991,000 0.65
1932 521,000 0.34 (low price in 1932–11/2)
favorable “trend” of earnings, in part by the high recent and current earnings and in part by the reckless standards of appraisal beginning to prevail at the time.
See pp. 438–440 of the 1934 edition of this work for a companion case—The Gabriel Company.
A third variety of this kind of reasoning could be applied to the brew- ery-stock flotations in 1933. These issues showed substantial current or prospective earnings based upon capacity operations and the i |
1,000 0.34 (low price in 1932–11/2)
favorable “trend” of earnings, in part by the high recent and current earnings and in part by the reckless standards of appraisal beginning to prevail at the time.
See pp. 438–440 of the 1934 edition of this work for a companion case—The Gabriel Company.
A third variety of this kind of reasoning could be applied to the brew- ery-stock flotations in 1933. These issues showed substantial current or prospective earnings based upon capacity operations and the indicated profit per barrel. Without claiming the gift of second sight, an analyst could confidently predict that the flood of capital being poured into this new industry would ultimately result in overcapacity and keen competition.
Hence a continued large return on the actual cash investment was scarcely probable; it was likely, moreover, that many of the individual companies would prove financial failures, and most of the others would be unable to earn enough to justify the optimistic price quotations engen- dered by their initial success.9
9 See Appendix Note 55, p. 792 on accompanying CD, for brief comments on the subsequent performance of the brewery issues of 1933.
Chapter 38
SPECIFIC REASONS FOR QUESTIONING
OR REJECTING THE PAST RECORD
IN ANALYZING AN INDIVIDUAL company, each of the governing elements in the operating results must be scrutinized for signs of possible unfavor- able changes in the future. This procedure may be illustrated by various examples drawn from the mining field. The four governing elements in such situations would be: (1) life of the mine, (2) annual output, (3) pro- duction costs and (4) selling price. The significance of the first factor has already been discussed in connection with charges against earnings for depletion. Both the output and the costs may be affected adversely if the ore to be mined in the future differs from that previously mined in location, character or grade.1
Rate of Output and Operating Costs |
xamples drawn from the mining field. The four governing elements in such situations would be: (1) life of the mine, (2) annual output, (3) pro- duction costs and (4) selling price. The significance of the first factor has already been discussed in connection with charges against earnings for depletion. Both the output and the costs may be affected adversely if the ore to be mined in the future differs from that previously mined in location, character or grade.1
Rate of Output and Operating Costs. Examples: Calumet and Hecla Consolidated Copper Company. The reports of this copper producer for 1936 and previous years illustrate various questions with respect to ore reserves. The income account for 1936 may be summarized as follows:
Copper produced . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78,500,000 lb.
Copper sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95,200,000 lb. @ 9.80 cents
Profit before depreciation and depletion . . . . . . . . . . . . . . . . . . . . . . . $3,855,000
Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,276,000
Depletion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,726,000
Earned per share after depreciation but before
depletion on 2,006,000 shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1.29
1 When ore reserves are stated only as so many tons, or so many years of life, these data may be misleading in the absence of assurance regarding the quality of ore remaining. Example: The depletion charges of Alaska Juneau Gold Mining Company suggested a remaining life of some 85 years from 1934. The registration statement however, claimed only some 25 years of life from 1934. The implication (confirmed upon inquiry) is that the longer “life” included much low-grade ore of noncommercial character.
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only as so many tons, or so many years of life, these data may be misleading in the absence of assurance regarding the quality of ore remaining. Example: The depletion charges of Alaska Juneau Gold Mining Company suggested a remaining life of some 85 years from 1934. The registration statement however, claimed only some 25 years of life from 1934. The implication (confirmed upon inquiry) is that the longer “life” included much low-grade ore of noncommercial character.
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Early in 1937 the stock sold at $20 per share, a valuation of
$40,000,000 for the company, or $30,000,000 for the mining properties plus $10,000,000 for the working capital.
A detailed analysis of the make-up of the 1936 earnings would have shown them to be derived from four separate sources, approximately as follows:
Source of copper
Number of pounds, millions Profit before depreciation and depletion
Cents per pound (approximate) Total (approximate)
Copper previously produced 17.3 4.5 $ 775,000
Conglomerate mine 36.3 3.6 1,305,000
Ahmeek mine 23.0 3.3 760,000
Reclamation plants 19.2 5.3 1,015,000
95.8 4.0 $3,855,000
Of these four sources of profit, all but the smallest were definitely lim- ited in life. The sale of copper produced in prior years was obviously non- recurring. The mainstay of the company’s production for 70 years—the Conglomerate Branch—was facing exhaustion “in the course of 12 or 14 months.” The reclamation-plant copper, recovered by reworking old tail- ings and providing the cheapest metal, was limited to a life of 5 to 7 years. There remained as the only more permanent source of future output the Ahmeek Mine, which was the highest cost operation and which had therefore been shut down from April 1932 through 1935. (There were also certain other high-cost properties that were still shut down in 1936.) Analysis would indicate, therefore, that probably not mor |
rse of 12 or 14 months.” The reclamation-plant copper, recovered by reworking old tail- ings and providing the cheapest metal, was limited to a life of 5 to 7 years. There remained as the only more permanent source of future output the Ahmeek Mine, which was the highest cost operation and which had therefore been shut down from April 1932 through 1935. (There were also certain other high-cost properties that were still shut down in 1936.) Analysis would indicate, therefore, that probably not more than a total of some 7 to 8 millions in profit could be expected in the future from the Conglomerate and the reclamation operations. Hence, aside from new developments of a speculative character, the greater part of the 40 millions of valuation for the company would have to be supported by earnings from higher cost properties which had contributed only a minor
part of the 1936 results.2
2 In the 1934 edition of this book we discussed a similar situation existing in this company in 1927, at which time the largest part of the profits were being contributed by the reclama- tion-plant operations, which were known to have a limited life.
Freeport Sulphur Company. The exhibit of the then Freeport Texas Company in 1933 supplies the same type of problem for the analyst, and it also raises the question of the propriety of the use, under such circum- stances, of the past earnings record to support the sale of new securities. An issue of $2,500,000 of 6% cumulative convertible preferred stock was sold at $100 per share in January 1933 in order to raise funds to equip a new sulphur property leased from certain other companies.
The offering circular stated among other things:
1. That the sulphur reserves had an estimated life of at least 25 years based upon the average annual sales for 1928–1932;
2. That the earnings for the period 1928–1932 averaged $2,952,500, or 19.6 times the preferred-dividend requirement.
The implication of these statements would be that, assuming no change in |
k was sold at $100 per share in January 1933 in order to raise funds to equip a new sulphur property leased from certain other companies.
The offering circular stated among other things:
1. That the sulphur reserves had an estimated life of at least 25 years based upon the average annual sales for 1928–1932;
2. That the earnings for the period 1928–1932 averaged $2,952,500, or 19.6 times the preferred-dividend requirement.
The implication of these statements would be that, assuming no change in the price received for sulphur, the company could confidently be expected to earn over the next 25 years approximately the amounts earned in the past.
The facts in the case, however, did not warrant any such deduction. The company’s past earnings were derived from the operation of two proper- ties, at Bryanmound and at Hoskins Mound, respectively. The Bryan- mound area was owned by the company and had contributed the bulk of the profits. But by 1933 its life was “definitely limited” (in the words of the listing application); in fact the reserves were not likely to last more than about three years. The Hoskins Mound was leased from the Texas Company. After paying $1.06 per ton fixed royalty, no less than 70% of the remaining prof- its were payable to Texas Company as rental.3 One half of Freeport’s sales were required to be made from sulphur produced at Hoskins. The new property at Grande Ecaille, La., now to be developed, would require roy- alty payments amounting to some 40% of the net earnings.
When these facts are studied, it will be seen that the earnings of Freeport Texas for 1928–1932 had no direct bearing on the results to be expected from future operations. The sulphur reserves, stated to be good for 25 years, represented mineral located in an entirely different place and
3 The rate had been 50% until Freeport recouped its capital expenditures on the property. Illustrative of the general theme of this chapter is the break in Freeport’s price from 1091/4 to 655/8 in J |
t earnings.
When these facts are studied, it will be seen that the earnings of Freeport Texas for 1928–1932 had no direct bearing on the results to be expected from future operations. The sulphur reserves, stated to be good for 25 years, represented mineral located in an entirely different place and
3 The rate had been 50% until Freeport recouped its capital expenditures on the property. Illustrative of the general theme of this chapter is the break in Freeport’s price from 1091/4 to 655/8 in January-February 1928 coincident with the change in the royalty rate.
The student may examine a similar development in the case of Texas Gulf Sulphur, occur- ring in 1934–1935.
to be extracted under entirely different conditions from those obtaining in the past. A large profit-sharing royalty would be payable on the sulphur produced from the new project, whereas the old Bryanmound was owned outright by Freeport and hence its profits accrued 100% to the company. In addition to this known element of higher cost, great stress must be laid also upon the fact that the major future profits of Freeport were now expected from a new project. The Grande Ecaille property was not yet equipped and in operation, and hence it was subject to the many hazards that attach to enterprises in the development stage. The cost of production at the new mine might conceivably be much higher, or much lower, than at Bryanmound. From the standpoint of security analysis the important point is that, where two quite different properties are involved, you have two virtually separate enterprises. Hence the 1928–1932 record of Freeport Texas was hardly more relevant to its future history than were the figures
of some entirely different sulphur company, e.g., Texas Gulf Sulphur.
Returning once more to the business man’s viewpoint on security val- ues, the Freeport Texas exhibit suggests the following interesting line of reasoning. In June 1933 this enterprise was selling in the market for about
$32,000,000 (25 |
different properties are involved, you have two virtually separate enterprises. Hence the 1928–1932 record of Freeport Texas was hardly more relevant to its future history than were the figures
of some entirely different sulphur company, e.g., Texas Gulf Sulphur.
Returning once more to the business man’s viewpoint on security val- ues, the Freeport Texas exhibit suggests the following interesting line of reasoning. In June 1933 this enterprise was selling in the market for about
$32,000,000 (25,000 shares of preferred at 125 and 730,000 shares of com- mon at 40). The major portion of its future profits were expected to be derived from an investment of $3,000,000 to equip a new property leased from three large oil companies. Presumably these oil companies drove as good a bargain for themselves as possible in the terms of the lease. The market was in effect placing a valuation of some $20,000,000, or more, upon a new enterprise in which only $3,000,000 was to be invested. It was possible, of course, that this enterprise would prove to be worth much more than six times the money put into it. But from the standpoint of ordinary business procedure the payment of such an enormous premium for anticipated future results would appear imprudent in the extreme.4
Evidently the stock market—like the heart, in the French proverb—has reasons all its own. In the writers’ view, where these reasons depart
4 Since the Freeport Texas preferred issue was relatively small, representing less than one-tenth of the total market value of the company, this analysis would not call into question the safety of the senior issue, but reflects only upon the soundness of the valuation accorded the common stock—judged by investment standards. After 1933 the company did in fact encounter serious problems of production, which held down the earnings and depressed the market price, but these problems were later solved. Yet the maximum earnings attained by 1940—$3.30 per share in 1937—could scarcely jus |
one-tenth of the total market value of the company, this analysis would not call into question the safety of the senior issue, but reflects only upon the soundness of the valuation accorded the common stock—judged by investment standards. After 1933 the company did in fact encounter serious problems of production, which held down the earnings and depressed the market price, but these problems were later solved. Yet the maximum earnings attained by 1940—$3.30 per share in 1937—could scarcely justify the price of 49 paid by speculators in 1933.
violently from sound sense and business experience, common-stock buy- ers must inevitably lose money in the end, even though large speculative gains may temporarily accrue, and even though certain fortunate purchases may turn out to be permanently profitable.
The Future Price of the Product. The three preceding examples related to the future continuance of the rate of output and the operating costs upon which the past record of earnings was predicted. We must also consider such indications as may be available in regard to the future sell- ing price of the product. Here we must ordinarily enter into the field of surmise or of prophecy. The analyst can truthfully say very little about future prices, except that they fall outside the realm of sound prediction. Now and then a more illuminating statement may be justified by the facts. Adhering to the mining field for our examples, we may mention the enor- mous profits made by zinc producers during the Great War, because of the high price of spelter. Butte and Superior Mining Company earned no less than $64 per share before depreciation and depletion in the two years 1915–1916, as the result of obtaining about 13 cents per pound for its out- put of zinc, against a prewar average of about 51/4 cents. Obviously the future earning power of this company was almost certain to shrink far below the war-time figures, nor could these properly be taken together with the results of any other |
s during the Great War, because of the high price of spelter. Butte and Superior Mining Company earned no less than $64 per share before depreciation and depletion in the two years 1915–1916, as the result of obtaining about 13 cents per pound for its out- put of zinc, against a prewar average of about 51/4 cents. Obviously the future earning power of this company was almost certain to shrink far below the war-time figures, nor could these properly be taken together with the results of any other years in order to arrive at the average or supposedly “normal” earnings.5
Change in Status of Low-cost Producers. The copper-mining industry offers an example of wider significance. An analysis of companies in this field must take into account the fact that since 1914 a substantial number of new low-cost producers have been developed and that other companies have succeeded in reducing extraction costs through metallurgical improvements. This means that there has been a definite lowering of the “center of gravity” of production costs for the entire industry. Other things being equal, this would make for a lower selling price in the future than obtained in the past. (Such a development is more strikingly illustrated by the crude-rubber industry.) Differently stated, mines that formerly rated as low-cost producers, i.e., as having costs well below the average, may have lost this advantage, unless they have also greatly improved their technique
5 The same type of reasoning clearly applies to the volume of business due to war conditions, as well illustrated by the exhibits of airplane companies in 1939–1940.
of production. The analyst would have to allow for these developments in his calculations, by taking a cautious view of future copper prices—at least as compared with the prewar or the predepression average.6
Anomalous Prices and Price Relationships in the History of the
I.R.T. System. The checkered history of the Interborough Rapid Tran- sit System in New York City has pr |
s to the volume of business due to war conditions, as well illustrated by the exhibits of airplane companies in 1939–1940.
of production. The analyst would have to allow for these developments in his calculations, by taking a cautious view of future copper prices—at least as compared with the prewar or the predepression average.6
Anomalous Prices and Price Relationships in the History of the
I.R.T. System. The checkered history of the Interborough Rapid Tran- sit System in New York City has presented a great variety of divergences between market prices and the real or relative values ascertainable by analysis. Two of these discrepancies turn upon the fact that for specific reasons the then current and past earnings should not have been accepted as indicative of future earning power. In abbreviated form the details of these two situations are as follows:
For a number of years prior to 1918 the Interborough Rapid Transit Company was very prosperous. In the 12 months ended June 30, 1917, it earned $26 per share on its capital stock and paid dividends of $20 per share. Nearly all of this stock was owned by Interborough Consolidated Corporation, a holding concern (previously called Interborough-Metro- politan Corporation) which in turn had outstanding collateral trust bonds, 6% preferred stock and common stock. Including its share of the undistributed earnings of the operating company it earned about $11.50 per share on its preferred stock and about $2.50 on the common. The pre- ferred sold in the market at 60, and the common at 10. These issues were actively traded in, and they were highly recommended to the public by various financial agencies which stressed the phenomenal growth of the subway traffic.
A modicum of analysis would have shown that the real picture was entirely different from what appeared on the surface. New rapid transit facilities were being constructed under contract between the City of New York and the Interborough (as well as others under contract |
ferred sold in the market at 60, and the common at 10. These issues were actively traded in, and they were highly recommended to the public by various financial agencies which stressed the phenomenal growth of the subway traffic.
A modicum of analysis would have shown that the real picture was entirely different from what appeared on the surface. New rapid transit facilities were being constructed under contract between the City of New York and the Interborough (as well as others under contract between the City and the Brooklyn Rapid Transit Company). As soon as the new lines were placed in operation, which was to be the following year, the earn- ings available for Interborough were to be limited under this contract to the figure prevailing in 1911–1913, which was far less than the current
6 On the other hand, the rise in the price of gold in 1933 invalidated for statistical purposes previous earnings of gold producers based on $20.67 gold. Whether or not the future price of gold will remain at $35 is anyone’s guess, but there seems no reason to make any calcula- tions based on the old value.
profits. The City would then be entitled to receive a high return on its enormous investment in the new lines. If and after all such payments were made in full, including back accruals, the City and the Interborough would then share equally in surplus profits. However, the preferential pay- ments due the City would be so heavy that experts had testified that under the most favorable conditions it would be more than 30 years before there could be any surplus income to divide with the company.
The subjoined brief table shows the significance of these facts.
INTERBOROUGH RAPID TRANSIT SYSTEM
Item
Actual earnings 1917 Maximum earnings when contract with City became operative
Balance for I.R.T. stock $9,100,000 $5,200,000
Share applicable to Interborough
Consolidated Corp. 8,800,000 5,000,000
Interest on Inter. Consol. bonds 3,520,000 3,520,000
Balance for Inter. Consol. p |
conditions it would be more than 30 years before there could be any surplus income to divide with the company.
The subjoined brief table shows the significance of these facts.
INTERBOROUGH RAPID TRANSIT SYSTEM
Item
Actual earnings 1917 Maximum earnings when contract with City became operative
Balance for I.R.T. stock $9,100,000 $5,200,000
Share applicable to Interborough
Consolidated Corp. 8,800,000 5,000,000
Interest on Inter. Consol. bonds 3,520,000 3,520,000
Balance for Inter. Consol. pfd. 5,280,000 1,480,000
Preferred dividend requirements 2,740,000 2,740,000
Balance for Inter. Consol. common 2,540,000 1,260,000(d)
Earned per share, Inter. Consol. pfd. $11.50 $3.25
Earned per share, Inter. Consol. common 2.50 nil
The underlying facts proved beyond question, therefore, that instead of a brilliant future being in store for Interborough, it was destined to suf- fer a severe loss of earning power within a year’s time. It would then be quite impossible to maintain the $6 dividend on the holding company’s preferred stock, and no earnings at all would be available for the com- mon for a generation or more. On this showing it was mathematically certain that both Interborough Consolidated stock issues were worth far less than their current selling prices.7
7 Indications pointed strongly to manipulative efforts by insiders in 1916–1917 to foist these shares upon the public at high prices before the period of lower earnings began. The payment of full dividends on the preferred stock, during an interlude of large earnings known to be temporary, was inexcusable from the standpoint of corporate policy but understandable as a
The sequel not only bore out this criticism, which it was bound to do, but demonstrated also that where an upper limit of earnings or value is fixed, there is usually danger that the actual figure will be less than the maximum. The opening of the new subway lines coincided with a large increase in operating costs, due to war-time inflation; and |
ed stock, during an interlude of large earnings known to be temporary, was inexcusable from the standpoint of corporate policy but understandable as a
The sequel not only bore out this criticism, which it was bound to do, but demonstrated also that where an upper limit of earnings or value is fixed, there is usually danger that the actual figure will be less than the maximum. The opening of the new subway lines coincided with a large increase in operating costs, due to war-time inflation; and also, as was to be expected, it diminished the profits of the older routes. Interbor- ough Rapid Transit Company was promptly compelled to reduce its div- idend, and it was omitted entirely in 1919. In consequence the holding company, Interborough Consolidated, suspended its preferred dividends in 1918. The next year it defaulted the interest on its bonds, became bankrupt and disappeared from the scene, with the complete extinction of both its preferred and common stock. Two years later Interborough Rapid Transit Company, recently so prosperous, barely escaped an immi- nent receivership by means of a “voluntary” reorganization which extended a maturing note issue. When this extended issue matured in 1932, the company was again unable to pay, and this time receivers took over the property.
During the ten-year period between the two receivership applications another earnings situation developed, somewhat similar to that of 1917.8 In 1928 the Interborough reported earnings of $3,000,000, or $8.50 per share for its common stock, and the shares sold as high as 62. But these earnings included $4,000,000 of “back preferential” from the subway divi- sion. The latter represented a limited amount due the Interborough Rapid Transit out of subway earnings to make good a deficiency in the profits of the early years of operating the new lines. On June 30, 1928 the amount of back preferential remaining to be paid the company was only
device to aid in unloading stock. These dividend distrib |
or $8.50 per share for its common stock, and the shares sold as high as 62. But these earnings included $4,000,000 of “back preferential” from the subway divi- sion. The latter represented a limited amount due the Interborough Rapid Transit out of subway earnings to make good a deficiency in the profits of the early years of operating the new lines. On June 30, 1928 the amount of back preferential remaining to be paid the company was only
device to aid in unloading stock. These dividend distributions were not only unfair to the 41/2% bondholders, but, because of certain prior developments, they were probably illegal as well. (Reference to this aspect of the case was made in Chap. 20 on accompanying CD).
8 See Appendix Note 56, p. 792 on accompanying CD, for a concise discussion of the numer- ous anomalies in price between various Interborough System securities, viz.:
1. Between Interborough Metropolitan 41/2 s and Interborough Consolidated Preferred in 1919.
2. Between I.R.T. 5s and I.R.T. 7s in 1920.
3. Between I.R.T. stock and Manhattan “Modified” stock in 1929.
4. Between I.R.T. 5s and I.R.T. 7s in 1933.
5. Between Manhattan “Modified” and Manhattan “Unmodified” stock in 1933.
$1,413,000. Hence all the profits available for Interborough stock were due to a special source of revenue that could continue for only a few months longer. Heedless speculators, however, were capitalizing as permanent an earning power of Interborough stock which analysis would show was of entirely nonrecurrent and temporary character.
Chapter 39
PRICE-EARNINGS RATIOS FOR COMMON STOCKS. ADJUSTMENTS FOR CHANGES
IN CAPITALIZATION
IN PREVIOUS CHAPTERS various references have been made to Wall Street’s ideas on the relation of earnings to values. A given common stock is gen- erally considered to be worth a certain number of times its current earn- ings. This number of times, or multiplier, depends partly on the prevailing psychology and partly on the nature and record of the enterprise |
y nonrecurrent and temporary character.
Chapter 39
PRICE-EARNINGS RATIOS FOR COMMON STOCKS. ADJUSTMENTS FOR CHANGES
IN CAPITALIZATION
IN PREVIOUS CHAPTERS various references have been made to Wall Street’s ideas on the relation of earnings to values. A given common stock is gen- erally considered to be worth a certain number of times its current earn- ings. This number of times, or multiplier, depends partly on the prevailing psychology and partly on the nature and record of the enterprise. Prior to the 1927–1929 bull market ten times earnings was the accepted standard of measurement. More accurately speaking, it was the common point of departure for valuing common stocks, so that an issue would have to be considered exceptionally desirable to justify a higher ratio, and conversely. Beginning about 1927 the ten-times-earnings standard was super- seded by a rather confusing set of new yardsticks. On the one hand, there was a tendency to value common stocks in general more liberally than before. This was summarized in a famous dictum of a financial leader implying that good stocks were worth fifteen times their earnings.1 There was also the tendency to make more sweeping distinctions in the valua- tions of different kinds of common stocks. Companies in especially favored groups, e.g., public utilities and chain stores, in 1928–1929, sold at a very high multiple of current earnings, say, twenty-five to forty times. This was true also of the “blue chip” issues, which comprised leading units in miscellaneous fields. As pointed out before, these generous valuations
1 The wording of this statement, as quoted in the Wall Street Journal of March 26, 1928, was as follows: “ ‘General Motors shares, according to the Dow, Jones & Co. averages,’ Mr.
Raskob remarked, ‘should sell at fifteen times earning power, or in the neighborhood of
$225 per share, whereas at the present level of $180 they sell at approximately only twelve times current earnings.’ ”
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sed leading units in miscellaneous fields. As pointed out before, these generous valuations
1 The wording of this statement, as quoted in the Wall Street Journal of March 26, 1928, was as follows: “ ‘General Motors shares, according to the Dow, Jones & Co. averages,’ Mr.
Raskob remarked, ‘should sell at fifteen times earning power, or in the neighborhood of
$225 per share, whereas at the present level of $180 they sell at approximately only twelve times current earnings.’ ”
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were based upon the assumed continuance of the upward trend shown over a longer or shorter period in the past. Subsequent to 1932 there developed a tendency for prices to rule higher in relation to earnings because of the sharp drop in long-term interest rates.
Exact Appraisal Impossible. Security analysis cannot presume to lay down general rules as to the “proper value” of any given common stock. Practically speaking, there is no such thing. The bases of value are too shifting to admit of any formulation that could claim to be even reason- ably accurate. The whole idea of basing the value upon current earnings seems inherently absurd, since we know that the current earnings are constantly changing. And whether the multiplier should be ten or fifteen or thirty would seem at bottom a matter of purely arbitrary choice.
But the stock market itself has no time for such scientific scruples. It must make its values first and find its reasons afterwards. Its position is much like that of a jury in a breach-of-promise suit; there is no sound way of measuring the values involved, and yet they must be measured somehow and a verdict rendered. Hence the prices of common stocks are not carefully thought out computations but the resultants of a welter of human reactions. The stock market is a voting machine rather than a weighing machine. It responds to factual data not directly but only as |
t must make its values first and find its reasons afterwards. Its position is much like that of a jury in a breach-of-promise suit; there is no sound way of measuring the values involved, and yet they must be measured somehow and a verdict rendered. Hence the prices of common stocks are not carefully thought out computations but the resultants of a welter of human reactions. The stock market is a voting machine rather than a weighing machine. It responds to factual data not directly but only as they affect the decisions of buyers and sellers.
Limited Functions of the Analyst in Field of Appraisal of Stock Prices. Confronted by this mixture of changing facts and fluctuating human fancies, the securities analyst is clearly incapable of passing judg- ment on common-stock prices generally. There are, however, some con- crete, if limited, functions that he may carry on in this field, of which the following are representative:
1. He may set up a basis for conservative or investment valuation of common stocks, as distinguished from speculative valuations.
2. He may point out the significance of: (a) the capitalization structure; and (b) the source of income, as bearing upon the valuation of a given stock issue.
3. He may find unusual elements in the balance sheet which affect the implications of the earnings picture.
A Suggested Basis of Maximum Appraisal for Investment. The investor in common stocks, equally with the speculator, is dependent on
future rather than past earnings. His fundamental basis of appraisal must be an intelligent and conservative estimate of the future earning power. But his measure of future earnings can be conservative only if it is limited by actual performance over a period of time. We have suggested, however, that the profits of the most recent year, taken singly, might be accepted as the gage of future earnings, if (1) general business conditions in that year were not exceptionally good, (2) the company has shown an upward trend of earnings f |
is fundamental basis of appraisal must be an intelligent and conservative estimate of the future earning power. But his measure of future earnings can be conservative only if it is limited by actual performance over a period of time. We have suggested, however, that the profits of the most recent year, taken singly, might be accepted as the gage of future earnings, if (1) general business conditions in that year were not exceptionally good, (2) the company has shown an upward trend of earnings for some years past and (3) the investor’s study of the industry gives him confidence in its continued growth. In a very exceptional case, the investor may be justified in counting on higher earnings in the future than at any time in the past. This might follow from developments involv- ing a patent or the discovery of new ore in a mine or some similar specific and significant occurrence. But in most instances he will derive the invest- ment value of a common stock from the average earnings of a period between five and ten years. This does not mean that all common stocks with the same average earnings should have the same value. The common- stock investor (i.e., the conservative buyer) will properly accord a more lib- eral valuation to those issues which have current earnings above the average or which may reasonably be considered to possess better than average prospects or an inherently stable earning power. But it is the essence of our viewpoint that some moderate upper limit must in every case be placed on the multiplier in order to stay within the bounds of conservative valuation. We would suggest that about 20 times average earnings is as high a price as can be paid in an investment purchase of a common stock.
Although this rule is of necessity arbitrary in its nature, it is not entirely so. Investment presupposes demonstrable value, and the typical common stock’s value can be demonstrated only by means of an estab- lished, i.e., an average, earning power. But it is diffi |
every case be placed on the multiplier in order to stay within the bounds of conservative valuation. We would suggest that about 20 times average earnings is as high a price as can be paid in an investment purchase of a common stock.
Although this rule is of necessity arbitrary in its nature, it is not entirely so. Investment presupposes demonstrable value, and the typical common stock’s value can be demonstrated only by means of an estab- lished, i.e., an average, earning power. But it is difficult to see how aver- age earnings of less than 5% upon the market price could ever be considered as vindicating that price. Clearly such a price-earnings ratio could not provide that margin of safety which we have associated with the investor’s position. It might be accepted by a purchaser in the expecta- tion that future earnings will be larger than in the past. But in the origi- nal and most useful sense of the term such a basis of valuation is speculative.2 It falls outside the purview of common-stock investment.
2 See Appendix Note 57, p. 794 on accompanying CD, for a discussion of the relationship between bond-interest rates and the “multiplier” for common stocks.
Higher Prices May Prevail for Speculative Commitments. The intent of this distinction must be clearly understood. We do not imply that it is a mistake to pay more than 20 times average earnings for any common stock. We do suggest that such a price would be speculative. The purchase may easily turn out to be highly profitable, but in that case it will have proved a wise or fortunate speculation. It is proper to remark, moreover, that very few people are consistently wise or fortunate in their specula- tive operations. Hence we may submit, as a corollary of no small practi- cal importance, that people who habitually purchase common stocks at more than about 20 times their average earnings are likely to lose consid- erable money in the long run. This is the more probable because, in the absence of such a mecha |
ofitable, but in that case it will have proved a wise or fortunate speculation. It is proper to remark, moreover, that very few people are consistently wise or fortunate in their specula- tive operations. Hence we may submit, as a corollary of no small practi- cal importance, that people who habitually purchase common stocks at more than about 20 times their average earnings are likely to lose consid- erable money in the long run. This is the more probable because, in the absence of such a mechanical check, they are prone to succumb recur- rently to the lure of bull markets, which always find some specious argu- ment to justify paying extravagant prices for common stocks.
Other Requisites for Common Stocks of Investment Grade and a Corol- lary Therefrom. It should be pointed out that if 20 times average earn- ings is taken as the upper limit of price for an investment purchase, then ordinarily the price paid should be substantially less than this maximum. This suggests that about 12 or 121/2 times average earnings may be suit- able for the typical case of a company with neutral prospects. We must emphasize also that a reasonable ratio of market price to average earn- ings is not the only requisite for a common-stock investment. It is a nec- essary but not a sufficient condition. The company must be satisfactory also in its financial set-up and management, and not unsatisfactory in its prospects.
From this principle there follows another important corollary, viz.: An attractive common-stock investment is an attractive speculation. This is true because, if a common stock can meet the demand of a conservative investor that he get full value for his money plus not unsatisfactory future prospects, then such an issue must also have a fair chance of appreciat- ing in market value.
Examples of Speculative and Investment Common Stocks. Our definition of an investment basis for common-stock purchases is at vari- ance with the Wall Street practice in respect to common stocks o |
e common-stock investment is an attractive speculation. This is true because, if a common stock can meet the demand of a conservative investor that he get full value for his money plus not unsatisfactory future prospects, then such an issue must also have a fair chance of appreciat- ing in market value.
Examples of Speculative and Investment Common Stocks. Our definition of an investment basis for common-stock purchases is at vari- ance with the Wall Street practice in respect to common stocks of high rating. For such issues a price of considerably more than 20 times aver- age earnings is held to be warranted, and furthermore these stocks are designated as “investment issues” regardless of the price at which they
sell. According to our view, the high prices paid for “the best common stocks” make these purchases essentially speculative, because they require future growth to justify them. Hence common-stock investment opera- tions, as we define them, will occupy a middle ground in the market, lying between low-price issues that are speculative because of doubtful quality and well-entrenched issues that are speculative, none the less, because of their high price.
GROUP A: COMMON STOCKS SPECULATIVE IN DECEMBER 1938 BECAUSE OF THEIR HIGH PRICE (FIGURES ADJUSTED TO REFLECT CHANGES IN CAPITALIZATION)
Item Group A
General Electric Coca Cola Johns-Manville
Amount Earned per Share of
Common:
1938 $0.96 $5.95 $1.09
1937 2.20 5.73 5.80
1936 1.52 4.66 5.13
1935 0.97 3.48 2.17
1934 0.59 3.12 0.22
1933 0.38 2.20 0.64(d)
1932 0.41 2.17 4.47(d)
1931 1.33 2.96 0.45
1930 1.90 2.79 3.66
1929 2.24 2.56 8.09
10-yr. average $1.25 $3.56 $2.15
5-yr. average (1934–1938) $1.25 $4.59 $2.88
Bonds None None None
Pfd. Stock None 600,000 sh. @ 60 75,000 sh. @ 130
$36,000,000 $9,750,000
Common Stock 28,784,000 sh. @ 431/2 3,992,000 sh. @ 1321/4 850,000 sh. @ 105
$1,250,000,000 $529,500,000 $89,300,000
Total capitalization $1,250,000,000 $565,500,000 $99,050,000
Net tangible assets, |
1934 0.59 3.12 0.22
1933 0.38 2.20 0.64(d)
1932 0.41 2.17 4.47(d)
1931 1.33 2.96 0.45
1930 1.90 2.79 3.66
1929 2.24 2.56 8.09
10-yr. average $1.25 $3.56 $2.15
5-yr. average (1934–1938) $1.25 $4.59 $2.88
Bonds None None None
Pfd. Stock None 600,000 sh. @ 60 75,000 sh. @ 130
$36,000,000 $9,750,000
Common Stock 28,784,000 sh. @ 431/2 3,992,000 sh. @ 1321/4 850,000 sh. @ 105
$1,250,000,000 $529,500,000 $89,300,000
Total capitalization $1,250,000,000 $565,500,000 $99,050,000
Net tangible assets, 12/31/38 $335,182,000 $43,486,000 $48,001,000
Net current assets, 12/31/38 $155,023,000 $25,094,000 $17,418,000
Average earnings on com-
mon-stock price, 1929–1938 2.9% 2.7% 2.0%
Maximum earnings on com-
mon-stock price, 1929–1938 5.1% 4.5% 7.7%
Minimum earnings on com-
mon-stock price, 1929–1938 0.9% 1.6% (d)
Average earnings on com-
mon-stock price, 1934–1938 2.9% 3.5% 2.7%
These distinctions are illustrated by3 the accompanying nine exam- ples, taken as of December 31, 1938.
Comments on the Various Groups. The companies listed in Group A are representative of the so-called “first-grade” or “blue chip” industrials, which
GROUP B: COMMON STOCKS SPECULATIVE IN DECEMBER 1938 BECAUSE OF
THEIR IRREGULAR RECORD
Item Group B
Goodyear Tire and Rubber
Simmons Youngstown Sheet and Tube
Amount earned per share of
common:
1938 $1.34 $1.42 $0.89(d)
1937 1.95 2.88 6.79
1936 3.90 3.53 7.03
1935 0.12 1.14 0.64
1934 0.66(d) 0.84(d) 2.95(d)
1933 0.79(d) 0.04 7.76(d)
1932 4.24(d) 2.57(d) 11.75(d)
1931 0.04 0.79(d) 6.55(d)
1930 0.37(d) 1.05(d) 5.17
1929 10.23 4.15 17.28
10-yr. average $1.15 $0.79 $0.70
5-yr. average (1934–1938) $ 1.35 $1.63 $2.12
Bonds $50,235,000 $10,000,000 $87,000,000
Pfd. stock 650,000 sh. @ 108 None 150,000 sh. @ 81
70,250,000 12,165,000
Common stock 2,059,000 sh. @ 375/8 1,158,000 sh. @ 32 1,675,000 sh. @ 541/4
$77,500,000 $37,050,000 $90,900,000
Total capitalization $197,985,000 $47,050,000 $190,065,000
Net tangible assets, 12/31/38 $170,322 |
(d) 2.57(d) 11.75(d)
1931 0.04 0.79(d) 6.55(d)
1930 0.37(d) 1.05(d) 5.17
1929 10.23 4.15 17.28
10-yr. average $1.15 $0.79 $0.70
5-yr. average (1934–1938) $ 1.35 $1.63 $2.12
Bonds $50,235,000 $10,000,000 $87,000,000
Pfd. stock 650,000 sh. @ 108 None 150,000 sh. @ 81
70,250,000 12,165,000
Common stock 2,059,000 sh. @ 375/8 1,158,000 sh. @ 32 1,675,000 sh. @ 541/4
$77,500,000 $37,050,000 $90,900,000
Total capitalization $197,985,000 $47,050,000 $190,065,000
Net tangible assets, 12/31/38 $170,322,000 $28,446,000 $224,678,000
Net current assets, 12/31/38 $96,979,000 $14,788,000 $83,375,000
Average earnings on com-
mon-stock price, 1929–1938 3.1% 2.5% 1.3%
Maximum earnings on com-
mon-stock price, 1929–1938 27.2% 13.0% 31.8%
Minimum earnings on com-
mon-stock price, 1929–1938 (d) (d) (d)
Average earnings on com-
mon-stock price, 1934–1938 3.6% 5.1% 3.9%
3 See Appendix Note 58, p. 795 on accompanying CD, for the examples given in the 1934 edition, and their later performance.
were particularly favored in the great speculation of 1928–1929 and in the markets of ensuing years. They are characterized by a strong financial posi- tion, by presumably excellent prospects and in most cases by relatively sta- ble or growing earnings in the past. The market price of the shares, however, was higher than would be justified by their average earnings. In fact the profits of the best year in the 1929–1938 decade were less than 8% of the
GROUP C: COMMON STOCKS MEETING INVESTMENT TESTS IN DECEMBER 1938 FROM THE
QUANTITATIVE STANDPOINT
Item Group C
Adams-Millis American Safety Razor
J. J. Newberry
Amount earned per share of
common:
1938 $3.21 $1.48 $4.05
1937 2.77 2.47 5.27
1936 2.55 2.70 6.03
1935 2.93 2.42 4.94
1934 3.41 2.03 5.38
1933 2.63 1.40 3.06
1932 1.03 1.14 1.07
1931 4.72 1.58 1.73
1930 4.83 2.50 2.27
1929 4.83 2.57 3.15
10-yr. average $3.29 $2.03 $3.70
5-yr. average (1934–1938) $2.97 $2.22 $5.13
Bonds None None $5,587,000
Pfd. stock None None 51,0 |
T TESTS IN DECEMBER 1938 FROM THE
QUANTITATIVE STANDPOINT
Item Group C
Adams-Millis American Safety Razor
J. J. Newberry
Amount earned per share of
common:
1938 $3.21 $1.48 $4.05
1937 2.77 2.47 5.27
1936 2.55 2.70 6.03
1935 2.93 2.42 4.94
1934 3.41 2.03 5.38
1933 2.63 1.40 3.06
1932 1.03 1.14 1.07
1931 4.72 1.58 1.73
1930 4.83 2.50 2.27
1929 4.83 2.57 3.15
10-yr. average $3.29 $2.03 $3.70
5-yr. average (1934–1938) $2.97 $2.22 $5.13
Bonds None None $5,587,000
Pfd. stock None None 51,000 sh. @ 106
$5,405,000
Common stock 156,000 sh. @ 21 524,000 sh. @ 147/8 380,000 sh. @ 341/2
$3,280,000 $7,800,000 $13,110,000
Total capitalization $3,280,000 $7,800,000 $24,102,000
Net tangible assets, 12/31/38 $3,320,000 $6,484,000 $25,551,000
Net current assets, 12/31/38 $926,000 $3,649,000 $8,745,000
Average earnings on com-
mon-stock price, 1929–1938 15.7% 13.7% 10.7%
Maximum earnings on com-
mon-stock price, 1929–1938 23.0% 18.2% 17.5%
Minimum earnings on com-
mon-stock price, 1929–1938 4.9% 7.7% 3.1%
Average earnings on com-
mon-stock price, 1934–1938 14.1% 14.9% 14.9%
December 1938 market price. It is also characteristic of such issues that they sell for enormous premiums above the actual capital invested.
The companies analyzed in Group B are obviously speculative, because of the great instability of their earnings records. They show vary- ing relationships of market price to average earnings, maximum earnings, and asset values.
The common stocks shown in Group C are examples of those which meet specific and quantitative tests of investment quality. These tests include the following:
1. The earnings have been reasonably stable, allowing for the tremendous fluctuations in business conditions during the ten-year period.
2. The average earnings bear a satisfactory ratio to market price.4
3. The financial set-up is sufficiently conservative, and the working-capital position is strong.
Although we do not suggest that a common stock bought for invest- me |
oup C are examples of those which meet specific and quantitative tests of investment quality. These tests include the following:
1. The earnings have been reasonably stable, allowing for the tremendous fluctuations in business conditions during the ten-year period.
2. The average earnings bear a satisfactory ratio to market price.4
3. The financial set-up is sufficiently conservative, and the working-capital position is strong.
Although we do not suggest that a common stock bought for invest- ment be required to show asset values equal to the price paid, it is none the less characteristic of issues in Group C that, as a whole, they will not sell for a huge premium above the companies’ actual resources.
Common-stock investment, as we envisage it, will confine itself to issues making exhibits of the kind illustrated by Group C. But the actual purchase of any such issues must require also that the purchaser be satisfied in his own mind that the prospects of the enterprise are at least reasonably favorable.
ALLOWANCES FOR CHANGES IN CAPITALIZATION
In dealing with the past record of earnings, when given on a per-share basis, it is elementary that the figures must be adjusted to reflect any important changes in the capitalization which have taken place during the period. In the simplest case these will involve a change only in the number of shares of common stock due to stock dividends, split-ups, etc. All that is necessary then is to restate the capitalization throughout the period on the basis of the current number of shares. (Such recalculations are made by some of the statistical services but not by others.)
4 Note that the average earnings of the three companies in Group C were nearly two and one-half times as large relative to market price as the maximum earnings of the companies in Group A.
When the change in capitalization has been due to the sale of addi- tional stock at a comparatively low price (usually through the exercise of subscription rights or warran |
iod on the basis of the current number of shares. (Such recalculations are made by some of the statistical services but not by others.)
4 Note that the average earnings of the three companies in Group C were nearly two and one-half times as large relative to market price as the maximum earnings of the companies in Group A.
When the change in capitalization has been due to the sale of addi- tional stock at a comparatively low price (usually through the exercise of subscription rights or warrants) or to the conversion of senior securities, the adjustment is more difficult. In such cases the earnings available for the common during the earlier period must be increased by whatever gain would have followed from the issuance of the additional shares. When bonds or preferred stocks have been converted into common, the charges formerly paid thereon are to be added back to the earnings and the new figure then applied to the larger number of shares. If stock has been sold at a relatively low price, a proper adjustment would allow earn- ings of, say, 5 to 8% on the proceeds of the sale. (Such recalculations need not be made unless the changes indicated thereby are substantial.)
A corresponding adjustment of the per-share earnings must be made at times to reflect the possible future increase in the number of shares out- standing as a result of conversions or exercise of option warrants. When other security holders have a choice of any kind, sound analysis must allow for the possible adverse effect upon the per-share earnings of the common stock that would follow from the exercise of the option.
Examples: This type of adjustment must be made in analyzing the reported earnings of American Airlines, Inc., for the 12 months ended September 30, 1939.
Earnings as reported . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,128,000 Per share on about 300,000 shares outstanding. . . . . . $3.76
(Price December 1939 about 37)
But there were outstanding $2,600,000 of 41/2% deb |
dverse effect upon the per-share earnings of the common stock that would follow from the exercise of the option.
Examples: This type of adjustment must be made in analyzing the reported earnings of American Airlines, Inc., for the 12 months ended September 30, 1939.
Earnings as reported . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,128,000 Per share on about 300,000 shares outstanding. . . . . . $3.76
(Price December 1939 about 37)
But there were outstanding $2,600,000 of 41/2% debentures, convert- ible into common stock at $12.50 per share. The analyst must assume con- version of the bonds, giving the following adjusted result:
Earnings, adding back $117,000 interest . . . . . . . . . . . $1,245,000 Per share on 508,000 shares . . . . . . . . . . . . . . . . . . . . . . $2.45
More than one-third of the reported earnings per share are lost when the necessary adjustment is made.
American Water Works and Electric Company can be used to illus- trate both types of adjustment. (See page 505.)
Adjustment A reflects the payment of stock dividends in 1928, 1929 and 1930.
Adjustment B assumes conversion of the $15,000,000 of convertible 5s, issued in 1934, thus increasing the earnings by the amount of the interest charges but also increasing the common-stock issue by 750,000 shares. (The foregoing adjustments are independent of any possible modifications in the reported earnings arising from the questioning of the depreciation charges, etc., as previously discussed.)
Year Earnings* for common as reported
Adjustment A
Adjustment B
Amount of shares
Number Per share Number of shares Earned per share
Amount Number of shares Earned per share
1933 $2,392 1,751 $1.37 1,751 $1.37 $3,140 2,501 $1.26
1932 2,491 1,751 1.42 1,751 1.42 3,240 2,501 1.30
1931 4,904 1,751 2.80 1,751 2.80 5,650 2,501 2.26
1930 5,424 1,751 3.10 1,751 3.10 6,170 2,501 2.47
1929 6,621 1,657 4.00 1,741 3.80 7,370 2,491 2.95
1928 5,009 1,432 3.49 1,739 2.88 5,760 2,489 2.30
1927
7-year a |
Year Earnings* for common as reported
Adjustment A
Adjustment B
Amount of shares
Number Per share Number of shares Earned per share
Amount Number of shares Earned per share
1933 $2,392 1,751 $1.37 1,751 $1.37 $3,140 2,501 $1.26
1932 2,491 1,751 1.42 1,751 1.42 3,240 2,501 1.30
1931 4,904 1,751 2.80 1,751 2.80 5,650 2,501 2.26
1930 5,424 1,751 3.10 1,751 3.10 6,170 2,501 2.47
1929 6,621 1,657 4.00 1,741 3.80 7,370 2,491 2.95
1928 5,009 1,432 3.49 1,739 2.88 5,760 2,489 2.30
1927
7-year average 3,660 1,361 2.69
$2.70 1,737 2.11
$2.50 4,410 2,487 1.76
$2.04
* Number of shares and earnings in thousands.
Corresponding adjustments in book values or current-asset values per share of common stock should be made in analyzing the balance sheet. This technique is followed in our discussion of the Baldwin Locomotive Works exhibit in Appendix Note 70, page 838 on accompanying CD, in which outstanding warrants are allowed for.
ALLOWANCES FOR PARTICIPATING INTERESTS
In calculating the earnings available for the common, full recognition must be given to the rights of holders of participating issues, whether or not the amounts involved are actually being paid thereon. Similar allowances must be made for the effect of management contracts provid- ing for a substantial percentage of the profits as compensation, as in the case of investment trusts. Unusual cases sometimes arise involving “restricted shares,” dividends on which are contingent upon earnings or other considerations.
Example: Trico Products Corporation, a large manufacturer of auto- mobile accessories, is capitalized at 675,000 shares of common stock, of which 450,000 shares (owned by the president) were originally “restricted” as to dividends. The unrestricted stock is first entitled to
dividends of $2.50 per share, after which both classes share equally in further dividends. In addition, successive blocks of the restricted stock were to be released from the restriction according as the earnings for 1925 a |
xample: Trico Products Corporation, a large manufacturer of auto- mobile accessories, is capitalized at 675,000 shares of common stock, of which 450,000 shares (owned by the president) were originally “restricted” as to dividends. The unrestricted stock is first entitled to
dividends of $2.50 per share, after which both classes share equally in further dividends. In addition, successive blocks of the restricted stock were to be released from the restriction according as the earnings for 1925 and successive years reached certain stipulated figures. (To the end of 1938, a total of 239,951 shares had been thus released.)
ADJUSTED EARNINGS: TRICO PRODUCTS CORPORATION1
Year
Earnings for common Earned per share on unrestricted stock
A. Ignoring restricted shares
B. Maximum distribution on unrestricted
shares C. Allowing for release of
restricted shares (i.e., on total capitalization)
1929 $2,250,000 $6.67 $4.58 $3.33
1930 1,908,000 5.09 3.94 2.83
1931 1,763,000 4.70 3.72 2.61
1932 965,000 2.57 2.54 1.44
1933 1,418,000 3.78 3.21 2.10
1934 1,772,000 4.72 3.74 2.62
1935 3,567,000 9.84 6.52 5.38
1936 4,185,000 9.75 7.25 6.39
1937 3,792,000 8.97 6.82 5.99
1938 2,320,000 5.56 4.53 3.70
10-year average $3,394,000 $6.17 $4.69 $3.64
1 The calculations for the years 1935–1938 have been affected by repurchases of unrestricted shares by the corporation.
In the above table Column C supplies the soundest measure of the earning power shown for the unrestricted shares. Column A is irrelevant.
A situation similar to that in Trico Products Corporation obtained in the case of Montana Power Company stock prior to June 1921.
General Rule. The material in the last few pages may be summarized in the following general rule:
The intrinsic value of a common stock preceded by convertible securities, or subject to dilution through the exercise of stock options or through partici- pating privileges enjoyed by other security holders, cannot reasonably be appraised at a higher figure |
is irrelevant.
A situation similar to that in Trico Products Corporation obtained in the case of Montana Power Company stock prior to June 1921.
General Rule. The material in the last few pages may be summarized in the following general rule:
The intrinsic value of a common stock preceded by convertible securities, or subject to dilution through the exercise of stock options or through partici- pating privileges enjoyed by other security holders, cannot reasonably be appraised at a higher figure than would be justified if all such privileges were exercised in full.
Chapter 40
CAPITALIZATION STRUCTURE
THE DIVISION of a company’s total capitalization between senior securities and common stock has an important bearing upon the significance of the earning power per share. A set of hypothetical examples will help make this point clear. For this purpose we shall postulate three industrial com- panies, A, B and C, each with an earning power (i.e., with average and recent earnings) of $1,000,000. They are identical in all respects save cap- italization structure. Company A is capitalized solely at 100,000 shares of common stock. Company B has outstanding $6,000,000 of 4% bonds and 100,000 shares of common stock. Company C has outstanding $12,000,000 of 4% bonds and 100,000 shares of common stock.
We shall assume that the bonds are worth par and that the common stocks are worth about 12 times their per-share earnings. Then the value of the three companies will work out as follows:
Company Earnings for common stock Value of common stock Value of bonds Total value of company
A $1,000,000 $12,000,000 $12,000,000
B 760,000 9,000,000 $6,000,000 15,000,000
C 520,000 6,000,000 12,000,000 18,000,000
These results challenge attention. Companies with identical earning power appear to have widely differing values, due solely to the arrange- ment of their capitalization. But the capitalization structure is itself a mat- ter of voluntary determination by those in control. Does |
s:
Company Earnings for common stock Value of common stock Value of bonds Total value of company
A $1,000,000 $12,000,000 $12,000,000
B 760,000 9,000,000 $6,000,000 15,000,000
C 520,000 6,000,000 12,000,000 18,000,000
These results challenge attention. Companies with identical earning power appear to have widely differing values, due solely to the arrange- ment of their capitalization. But the capitalization structure is itself a mat- ter of voluntary determination by those in control. Does this mean that the fair value of an enterprise can be arbitrarily increased or decreased by changing around the relative proportions of senior securities and common stock?
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Can the Value of an Enterprise Be Altered through Arbitrary Variations in Capital Structure? To answer this question properly we must scrutinize our examples with greater care. In working out the value of the three companies we assumed that the bonds would be worth par and that the stocks would be worth twelve times their earnings. Are these assumptions tenable? Let us consider first the case of Company B. If there are no unfavorable elements in the picture, the bonds might well sell at about 100, since the interest is earned four times. Nor would the presence of this funded debt ordinarily prevent the common stock from selling at 12 times its established earning power.
It will be urged however, that, if Company B shares are worth 12 times their earnings, Company A shares should be worth more than this mul- tiple because they have no debt ahead of them. The risk is therefore smaller, and they are less vulnerable to the effect of a shrinkage in earn- ings than is the stock of Company B. This is obviously true, and yet it is equally true that Company B shares will be more responsive to an increase in earnings. The following figures bring this point out clearly:
Assumed earnings
Earned p |
at, if Company B shares are worth 12 times their earnings, Company A shares should be worth more than this mul- tiple because they have no debt ahead of them. The risk is therefore smaller, and they are less vulnerable to the effect of a shrinkage in earn- ings than is the stock of Company B. This is obviously true, and yet it is equally true that Company B shares will be more responsive to an increase in earnings. The following figures bring this point out clearly:
Assumed earnings
Earned per share Change in earnings per share from base
Co. A Co. B Co. A Co. B
$1,000,000 $10.00 $ 7.60 (Base) (Base)
750,000 7.50 5.10 -25% -33%
1,250,000 12.50 10.10 +25% +33%
Would it not be fair to assume that the greater sensitivity of Company B to a possible decline in profits is offset by its greater sensitivity to a pos- sible increase? Furthermore, if the investor expects higher earnings in the future—and presumably he selects his common stocks with this in mind—would he not be justified in selecting the issue that will benefit more from a given degree of improvement? We are thus led back to the original conclusions that Company B may be worth $3,000,000, or 25% more than Company A due solely to its distribution of capitalization between bonds and stock.
Principle of Optimum Capitalization Structure. Paradoxical as this conclusion may seem, it is supported by the actual behavior of common stocks in the market. If we subject this contradiction to closer analysis, we
shall find that it arises from what may be called an oversimplification of Company A’s capital structure. Company A’s common stock evidently con- tains the two elements represented by the bonds and stock of Company B. Part of Company A’s stock is at bottom equivalent to Company B’s bonds and should in theory be valued on the same basis, i.e., 4%. The remainder of Company A’s stock should then be valued at 12 times earnings. This the- oretical reasoning would give us a combined value of $15,000,000, i.e., an av |
it arises from what may be called an oversimplification of Company A’s capital structure. Company A’s common stock evidently con- tains the two elements represented by the bonds and stock of Company B. Part of Company A’s stock is at bottom equivalent to Company B’s bonds and should in theory be valued on the same basis, i.e., 4%. The remainder of Company A’s stock should then be valued at 12 times earnings. This the- oretical reasoning would give us a combined value of $15,000,000, i.e., an average 62/3% basis, for the two components of Company A stock, which, of course, is the same as that of Company B bonds and stock taken together. But this $15,000,000 value for Company A stock would not ordinar-
ily be realized in practice. The obvious reason is that the common-stock buyer will rarely recognize the existence of a “bond component” in a com- mon-stock issue, and in any event, not wanting such a bond component, he is unwilling to pay extra for it.1 This fact leads us to an important prin- ciple, both for the security buyer and for corporate management, viz.:
The optimum capitalization structure for any enterprise includes sen- ior securities to the extent that they may safely be issued and bought for investment.
Concretely this means that the capitalization arrangement of Company B is preferable to that of Company A from the stockholder’s standpoint, assuming that in both cases the $6,000,000 bond issue would constitute a sound investment. (This might require, among other things, that the com- panies show a net working capital of not less than $6,000,000 in accordance with the stringent tests for sound industrial issues recommended in Chap. 13, which is on accompanying CD.) Under such conditions the contribu- tion of the entire capital by the common stockholders may be called an over- conservative set-up, as it tends generally to make the stockholder’s dollar less productive to him than if a reasonable part of the capital were borrowed. An analogous situation hol |
things, that the com- panies show a net working capital of not less than $6,000,000 in accordance with the stringent tests for sound industrial issues recommended in Chap. 13, which is on accompanying CD.) Under such conditions the contribu- tion of the entire capital by the common stockholders may be called an over- conservative set-up, as it tends generally to make the stockholder’s dollar less productive to him than if a reasonable part of the capital were borrowed. An analogous situation holds true in most private businesses, where it is
1 See our discussion of American Laundry Machinery Company on pp. 505–507 of the 1934 edition of this work for an illustration of the possible effect of a change of capital structure from an all-stock to a stock-and-bond combination. Actual changes of this kind were made by American Zinc (through a dividend in preferred stock in 1916) and by Maytag Company through similar distributions in 1928. The usual method of introducing a speculative capital- ization structure into a company with a conservative set-up is through formation of a holding company that issues its own senior securities and common stock against acquisition of the operating company’s common. Examples: Chesapeake Corporation in 1927, Kaufmann Department Stores Securities Corporation in 1925.
recognized as profitable and proper policy to use a conservative amount of banking accommodation for seasonal needs rather than to finance operations entirely by owners’ capital.
Corporate Practices Resulting in Shortage of Sound Industrial Bonds. Furthermore, just as it is desirable from the bank’s standpoint that sound businesses borrow seasonally, it is also desirable from the standpoint of investors generally that strong industrial corporations raise an appropriate part of their capital through the sale of bonds. Such a pol- icy would increase the number of high-grade bond issues on the market, giving the bond investor a wider range of choice and making it deservedly dif |
orate Practices Resulting in Shortage of Sound Industrial Bonds. Furthermore, just as it is desirable from the bank’s standpoint that sound businesses borrow seasonally, it is also desirable from the standpoint of investors generally that strong industrial corporations raise an appropriate part of their capital through the sale of bonds. Such a pol- icy would increase the number of high-grade bond issues on the market, giving the bond investor a wider range of choice and making it deservedly difficult to sell unsound bonds. Unfortunately the practice of industrial corporations in recent years has tended to produce a shortage of good industrial bond issues. Strong enterprises have in general refrained from floating new bonds and in many cases have retired old ones. But this avoidance of bonded debt by the strongest industrial companies has in fact produced results demoralizing to investors and investment policies in a number of ways. The following observations on this point, written in 1934, are still applicable in good part:
1. It has tended to restrict new industrial-bond financing to companies of weaker standing. The relative scarcity of good bonds impelled investment houses to sell and investors to buy inferior issues, with inevitably disastrous results.
2. The shortage of good bonds also tended to drive investors into the pre- ferred-stock field. For reasons previously detailed (in Chap. XIV) straight preferred stocks are unsound in theory, and they are therefore likely to prove unsatisfactory investment media as a class.
3. The elimination (or virtual elimination) of senior securities in the set-up of many large corporations has, of course, added somewhat to the invest- ment quality of their common stocks, but it has added even more to the investor’s demand for these common stocks. This in turn has resulted in a good deal of common-stock buying by people whose circumstances required that they purchase sound bonds. Furthermore it has supplied a superficial justi |
o prove unsatisfactory investment media as a class.
3. The elimination (or virtual elimination) of senior securities in the set-up of many large corporations has, of course, added somewhat to the invest- ment quality of their common stocks, but it has added even more to the investor’s demand for these common stocks. This in turn has resulted in a good deal of common-stock buying by people whose circumstances required that they purchase sound bonds. Furthermore it has supplied a superficial justification for the creation of excessive prices for these common stocks; and finally it contributed powerfully to that confusion between investment motives and speculative motives which during 1927–1929 served to debauch so large a proportion of the country’s erstwhile careful investors.
Appraisal of Earnings Where Capital Structure Is Top-heavy. In order to carry this theory of capitalization structure a step further, let us examine the case of Company C. We arrived at a valuation of $18,000,000 for this enterprise by assuming that its $12,000,000 bond issue would sell at par and the stock would sell for 12 times its earnings of $5.20 per share. But this assumption as to the price of the bonds is clearly fallacious. Earn- ings of twice interest charges are not sufficient protection for an industrial bond, and hence investors would be unwise to purchase such an issue at par. In fact this very example supplies a useful demonstration of our con- tention that a coverage of two times interest is inadequate. If it were ample—as some investors seem to believe—the owners of any reasonably prosperous business, earning 8% on the money invested, could get back their entire capital by selling a 4% bond issue, and they would still have control of the business together with one-half of its earnings. Such an arrangement would be exceedingly attractive for the proprietors but idiotic from the standpoint of those who buy the bonds.
Our Company C example also sheds some light on the effect of |
est is inadequate. If it were ample—as some investors seem to believe—the owners of any reasonably prosperous business, earning 8% on the money invested, could get back their entire capital by selling a 4% bond issue, and they would still have control of the business together with one-half of its earnings. Such an arrangement would be exceedingly attractive for the proprietors but idiotic from the standpoint of those who buy the bonds.
Our Company C example also sheds some light on the effect of the rate of interest on the apparent safety of the senior security. If the
$12,000,000 bond issue had carried a 6% coupon, the interest charges of
$720,000 would then be earned less than 11/2 times. Let us assume that Company D had such a bond issue. An unwary investor, looking at the two exhibits, might reject Company D’s 6% bonds as unsafe because their interest coverage was only 1.39 but yet accept the Company C bonds at par because he was satisfied with earnings of twice fixed charges. Such discrimination would be scarcely intelligent. Our investor would be rejecting a bond merely because it pays him a generous coupon rate, and he would be accepting another bond merely because it pays him a low interest rate. The real point, however, is that the minimum margin of safety behind bond issues must be set high enough to avoid the possibil- ity that safety may even appear to be achieved by a mere lowering of the interest rate. The same reasoning would apply of course to the dividend rate on preferred stocks.
Since Company C bonds are not safe, because of the excessive size of the issue, they are likely to sell at a considerable discount from par. We cannot suggest the proper price level for such an issue, but we have indi- cated in Chap. 26 that a bond speculative because of inadequate safety should not ordinarily be purchased above 70. It is also quite possible that the presence of this excessive bond issue might prevent the stock from
selling at 12 times its earnings, beca |
e on preferred stocks.
Since Company C bonds are not safe, because of the excessive size of the issue, they are likely to sell at a considerable discount from par. We cannot suggest the proper price level for such an issue, but we have indi- cated in Chap. 26 that a bond speculative because of inadequate safety should not ordinarily be purchased above 70. It is also quite possible that the presence of this excessive bond issue might prevent the stock from
selling at 12 times its earnings, because conservative stock buyers would avoid Company C as subject to too great hazard of financial difficulties in the event of untoward developments. The result may well be that, instead of being worth $18,000,000 in the market as originally assumed, the combined bond and stock issues of Company C will sell for less than
$15,000,000 (the Company B valuation), or even for less than $12,000,000 (the value of Company A).
As a matter of cold fact, it should be recognized that this unfavorable result may not necessarily follow. If investors are sufficiently careless and if speculators are sufficiently enthusiastic, the securities of Company C may conceivably sell in the market for $18,000,000 or even more. But such a situation would be unwarranted and unsound.2 Our theory of capital- ization structure could not admit a Company C arrangement as in any sense standard or suitable. This indicates that there are definite limits upon the advantages to be gained by the use of senior securities. We have already expressed this fact in our principle of the optimum capitalization structure, for senior securities cease to be an advantage at the point where their amount becomes larger than can safely be issued or bought for investment.
We have characterized the Company A type of capitalization arrange- ment as “overconservative”; the Company C type may be termed “specu- lative,” whereas that of Company B may well be called “suitable” or “appropriate.”
The Factor of Leverage in Speculative Capita |
ave already expressed this fact in our principle of the optimum capitalization structure, for senior securities cease to be an advantage at the point where their amount becomes larger than can safely be issued or bought for investment.
We have characterized the Company A type of capitalization arrange- ment as “overconservative”; the Company C type may be termed “specu- lative,” whereas that of Company B may well be called “suitable” or “appropriate.”
The Factor of Leverage in Speculative Capitalization Structure. Although a speculative capitalization structure throws all the company’s securities outside the pale of investment, it may give the common stock a definite speculative advantage. A 25% increase in the earnings of Com- pany C (from $1,000,000 to $1,250,000) will mean about a 50% increase in the earnings per share of common (from $5.20 to $7.70). Because of this fact there is some tendency for speculatively capitalized enterprises
2 In 1925 Dodge Brothers (motor) securities were sold to the public on the basis of
$160,000,000 principal value of bonds and preferred stock and about $50,000,000 market value of common. Net tangible assets were only $80,000,000, and average earnings about
$16,000,000. This obviously top-heavy capitalization structure did not militate against the security values at first, but a severe decline in earnings in 1927 soon revealed the unsound- ness of the financial setup. (In 1928 the company was taken over by Chrysler.)
to sell at relatively high values in the aggregate during good times or good markets. Conversely, of course, they may be subject to a greater degree of undervaluation in depression. There is, however, a real advantage in the fact that such issues, when selling on a deflated basis, can advance much further than they can decline.
AMERICAN WATER WORKS AND ELECTRIC COMPANY
Item
1921
1923
1924
1929 Ratio of 1929 figures to 1921 figures
Gross earnings* Net for charges*
Fixed charges and preferred dividends*
Bal |
high values in the aggregate during good times or good markets. Conversely, of course, they may be subject to a greater degree of undervaluation in depression. There is, however, a real advantage in the fact that such issues, when selling on a deflated basis, can advance much further than they can decline.
AMERICAN WATER WORKS AND ELECTRIC COMPANY
Item
1921
1923
1924
1929 Ratio of 1929 figures to 1921 figures
Gross earnings* Net for charges*
Fixed charges and preferred dividends*
Balance for common*
1921 basis:†
Number of shares of common
Earned per share
High price of common
% earned on high price of common
As reported:
Number of shares of common
Earned per share
High price of common $20,574 $36,380 $38,356 $54,119 2.63 :1
6,692 12,684 13,770 22,776 3.44 :1
6,353 11,315 12,780 16,154 2.54 :1
339 1,369 990 6,622 19.53 :1
92,000
100,000
100,000
130,000
1.41 :1
$3.68 $13.69 $9.90 $51.00 13.86 :1
61/2 443/4 209 about 2500 385.00 :1
56.6% 30.6% 4.7% 2.04% 0.037 :1
92,000
100,000
500,000
1,657,000
$3.68 $13.69 $1.98 $4.00
61/2 443/4 417/8 199
* In thousands.
† Number of shares and price adjusted to eliminate effect of stock dividends and split-ups.
The record of American Water Works and Electric Company com- mon stock between 1921 and 1929 presents an almost fabulous picture of enhancement in value, a great part of which was due to the influence of a highly speculative capitalization structure. Four annual exhibits dur- ing this period are summarized in the table above.
The purchaser of 1 share of American Water Works common stock at the high price of 61/2 in 1921, if he retained the distributions made in
stock, would have owned about 121/2 shares when the common sold at its high price of 199 in 1929. His $6.50 would have grown to about $2,500. While the market value of the common shares was thus increasing some 400-fold, the gross earnings had expanded to only 2.6 times the earlier figure. The tremendously disproportionate rise in th |
ized in the table above.
The purchaser of 1 share of American Water Works common stock at the high price of 61/2 in 1921, if he retained the distributions made in
stock, would have owned about 121/2 shares when the common sold at its high price of 199 in 1929. His $6.50 would have grown to about $2,500. While the market value of the common shares was thus increasing some 400-fold, the gross earnings had expanded to only 2.6 times the earlier figure. The tremendously disproportionate rise in the common-stock value was due to the following elements, in order of importance:
1. A much higher valuation placed upon the per-share earnings of this issue. In 1921 the company’s capitalization was recognized as top-heavy; its bonds sold at a low price, and the earnings per share of common were not taken seriously, especially since no dividends were being paid on the second preferred. In 1929 the general enthusiasm for public-utility shares resulted in a price for the common issue of nearly 50 times its highest recorded earnings.
2. The speculative capitalization structure allowed the common stock to gain an enormous advantage from the expansion of the com- pany’s properties and earnings. Nearly all the additional funds needed were raised by the sale of senior securities. It will be observed that whereas the gross revenues increased about 160% from 1921 to 1929, the balance per share of old common stock grew 14-fold during the same period.
3. The margin of profit improved during these years, as shown by the higher ratio of net to gross. The speculative capital structure greatly accentuated the benefit to the common stock from the additional net profits so derived.3
Other Examples: The behavior of speculatively capitalized enterprises under varying business conditions is well illustrated by the appended analysis of A. E. Staley Manufacturing Company, manufacturers of corn products. For comparison there is given also a corresponding analysis of American Maize Products Company, |
years, as shown by the higher ratio of net to gross. The speculative capital structure greatly accentuated the benefit to the common stock from the additional net profits so derived.3
Other Examples: The behavior of speculatively capitalized enterprises under varying business conditions is well illustrated by the appended analysis of A. E. Staley Manufacturing Company, manufacturers of corn products. For comparison there is given also a corresponding analysis of American Maize Products Company, a conservatively capitalized enter- prise in the same field.
The most striking aspect of the Staley exhibit is the extraordinary fluc- tuation in the yearly earnings per share of common stock. The business itself is evidently subject to wide variations in net profit, and the effect of
3 See Appendix Note 59, p. 799 on accompanying CD, for data illustrating the reverse process applied to American Water Works from 1929 through 1938; also for a similar specu- lative opportunity in United Light and Power Company Preferred Stock in 1935.
these variations on the common stock is immensely magnified by reason of the small amount of common stock in comparison with the senior securities.4 The large depreciation allowance acts also as the equivalent of a heavy fixed charge. Hence a decline in net before depreciation from
$3,266,000 in 1929 to $1,540,000 the next year, somewhat over 50%, resulted in a drop in earnings per share of common from $84 to only $3.74. The net profits of American Maize Products were fully as variable, but the small amount of prior charges made the fluctuations in common- stock earnings far less spectacular.
A. E. STALEY
Year
Net before depreciation*
Depreciation* Fixed charges and pfd. dividends*
Balance for common*
Earned per share
1933 $2,563 $743 $652 $1,168 $55.63
1932 1,546 753 678 114 5.43
1931 892 696 692 496(d) 23.60(d)
1930 1,540 753 708 79 3.74
1929 3,266 743 757 1,766 84.09
1928 1,491 641 696 154 7.35
1927 1,303 531 541 231 11.01
1926 2,43 |
Products were fully as variable, but the small amount of prior charges made the fluctuations in common- stock earnings far less spectacular.
A. E. STALEY
Year
Net before depreciation*
Depreciation* Fixed charges and pfd. dividends*
Balance for common*
Earned per share
1933 $2,563 $743 $652 $1,168 $55.63
1932 1,546 753 678 114 5.43
1931 892 696 692 496(d) 23.60(d)
1930 1,540 753 708 79 3.74
1929 3,266 743 757 1,766 84.09
1928 1,491 641 696 154 7.35
1927 1,303 531 541 231 11.01
1926 2,433 495 430 1,507 71.77
1925 792 452 358 18(d) 0.87(d)
1924 1,339 419 439 481 22.89
* 000 omitted.
4 In 1934 the company declared a 100% stock dividend, thus doubling the number of shares of common, and in 1937 split the stock 10 for 1 and changed the par value from $100 to $10. These two developments multiplied the outstanding shares by 20. Persistence of the variable factor in the earnings for the common stock is shown by the following per-share figures, based on the 1933 capitalization:
1934 $28.46
1935 2.76(d)
1936 52.88
1937 18.40(d)
1938 38.80
1939 68.00
AMERICAN MAIZE PRODUCTS
Year
Net before depreciation*
Depreciation* Fixed charges and pfd. dividends*
Balance for common*
Earned per share
1933 $1,022 $301 $721 $2.40
1932 687 299 388 1.29
1931 460 299 161 0.54
1930 1,246 306 22 918 3.06
1929 1,835 312 80 1,443 4.81
1928 906 317 105 484 1.61
1927 400 318 105 23(d) 0.08(d)
* 000 omitted.
CAPITALIZATION (AS OF JANUARY 1933)
Item A. E. Staley American Maize Products
6% bonds ($4,000,000* @ 75) $3,000,000
$7 pfd. stock (50,000 sh. @ 44) 2,200,000
Common stock (21,000 sh. @ 45) 950,000 (300,000 sh. @ 20) $6,000,000
Total capitalization $6,150,000 $6,000,000
Average earnings, 1927–1932,
about 900,000 615,000
% of these earning on 1933
capitalization 14.6% 10.3%†
Average earnings per sh. of
common $14.76 $1.87
% earned on price of common 32.8% 9.4%†
Working capital, Dec. 31, 1932 $3,664,000 $2,843,000
Net assets, Dec. 31, 1932 $15,000,000 $4,827,000
* De |
% bonds ($4,000,000* @ 75) $3,000,000
$7 pfd. stock (50,000 sh. @ 44) 2,200,000
Common stock (21,000 sh. @ 45) 950,000 (300,000 sh. @ 20) $6,000,000
Total capitalization $6,150,000 $6,000,000
Average earnings, 1927–1932,
about 900,000 615,000
% of these earning on 1933
capitalization 14.6% 10.3%†
Average earnings per sh. of
common $14.76 $1.87
% earned on price of common 32.8% 9.4%†
Working capital, Dec. 31, 1932 $3,664,000 $2,843,000
Net assets, Dec. 31, 1932 $15,000,000 $4,827,000
* Deducting estimated amount of bonds in treasury.
† The difference between these two figures is due to the varying treatment of the preferred stock outstanding during 1927–1930. A very small amount of preferred stock remaining in 1931–1933 is ignored in the above calculations.
Speculative Capitalization May Cause Valuation of Total Enter- prise at an Unduly Low Figure. The market situation of the Staley secu- rities in January 1933 presents a practical confirmation of our theoretical analysis of Company C above. The top-heavy capitalization structure
resulted in a low price for the bonds and the preferred stock, the latter being affected particularly by the temporary suspension of its dividend in 1931. The result was that, instead of showing an increased total value by reason of the presence of senior securities, the company sold in the market at a much lower relative price than the conservatively capitalized American Maize Products. (The latter company showed a normal relationship between aver- age earnings and market value. It should not properly be termed overcon- servatively capitalized because the variations in its annual earnings would constitute a good reason for avoiding any substantial amount of senior secu- rities. A bond or preferred stock issue of very small size, on the other hand, would be of no particular advantage or disadvantage.)
The indication that the A. E. Staley Company was undervalued in January 1933 in comparison with American Maize Products is strengt |
ween aver- age earnings and market value. It should not properly be termed overcon- servatively capitalized because the variations in its annual earnings would constitute a good reason for avoiding any substantial amount of senior secu- rities. A bond or preferred stock issue of very small size, on the other hand, would be of no particular advantage or disadvantage.)
The indication that the A. E. Staley Company was undervalued in January 1933 in comparison with American Maize Products is strength- ened by reference to the relative current-asset positions and total resources. Per dollar of net asset values the Staley company was selling only one-third as high as American Maize.
The overdeflation of a speculative issue like Staley common in unfa- vorable markets creates the possibility of an amazing price advance when conditions improve, because the earnings per share then show so violent an increase. Note that at the beginning of 1927 Staley common was quoted at about 75, and a year later it sold close to 300. Similarly the shares advanced from a low of 33 in 1932 to the equivalent of 320 in 1939. A Corresponding Example. A more spectacular instance of tremen- dous price changes for the same reason is supplied by Mohawk Rubber. In 1927 the common sold at 15, representing a valuation of only $300,000 for the junior issue, which followed $1,960,000 of preferred. The com- pany had lost $610,000 in 1926 on $6,400,000 of sales. In 1927 sales dropped to $5,700,000, but there was a net profit of $630,000. This amounted to over $23 per share on the small amount of common stock. The price consequently advanced from its low of 15 in 1927 to a high of 251 in 1928. In 1930 the company again lost $669,000, and the next year
the price declined to the equivalent of only $4.
In a speculatively capitalized enterprise, the common stockholders benefit—or have the possibility of benefiting—at the expense of the sen- ior security holders. The common stockholder is operating with a little |
et profit of $630,000. This amounted to over $23 per share on the small amount of common stock. The price consequently advanced from its low of 15 in 1927 to a high of 251 in 1928. In 1930 the company again lost $669,000, and the next year
the price declined to the equivalent of only $4.
In a speculatively capitalized enterprise, the common stockholders benefit—or have the possibility of benefiting—at the expense of the sen- ior security holders. The common stockholder is operating with a little of his own money and with a great deal of the senior security holder’s money; as between him and them it is a case of “Heads I win, tails you
lose.” This strategic position of the common stockholder with relatively small commitment is an extreme form of what is called “trading on the equity.” Using another expression, he may be said to have a “cheap call” on the future profits of the enterprise.
Speculative Attractiveness of “Shoe-string” Common Stocks Considered. Our discussion of fixed-value investment has emphasized as strongly as possible the disadvantage (amounting to unfairness) that attaches to the senior security holder’s position where the junior capital is proportionately slight. The question would logically arise if there are not corresponding advantages to the common stock in such an arrange- ment, from which it gains a very high degree of speculative attractive- ness. This inquiry would obviously take us entirely outside the field of common-stock investment but would represent an expedition into the realm of intelligent or even scientific speculation.
We have already seen from our A. E. Staley example that in bad times a speculative capitalization structure may react adversely on the market price of both the senior securities and the common stock. During such a period, then, the common stockholders do not derive a present benefit at the expense of the bondholder. This fact clearly detracts from the spec- ulative advantage inherent in such common stocks. It is |
present an expedition into the realm of intelligent or even scientific speculation.
We have already seen from our A. E. Staley example that in bad times a speculative capitalization structure may react adversely on the market price of both the senior securities and the common stock. During such a period, then, the common stockholders do not derive a present benefit at the expense of the bondholder. This fact clearly detracts from the spec- ulative advantage inherent in such common stocks. It is easy to suggest that these issues be purchased only when they are selling at abnormally low levels due to temporarily unfavorable conditions. But this is really begging the question, because it assumes that the intelligent speculator can consistently detect and wait for these abnormal and temporary con- ditions. If this were so, he could make a great deal of money regardless of what type of common stock he buys, and under such conditions he might be better advised to select high-grade common stocks at bargain prices rather than these more speculative issues.
Practical Aspects of the Foregoing. To view the matter in a practical light, the purchase of speculatively capitalized common stocks must be considered under general or market conditions that are supposedly nor- mal, i.e., under those which are not obviously inflated or deflated. Assum- ing (1) diversification, and (2) reasonably good judgment in selecting companies with satisfactory prospects, it would seem that the speculator should be able to profit rather substantially in the long run from commit- ments of this kind. In making such purchases, partiality should evidently be shown to those companies in which most of the senior capital is in the
form of preferred stock rather than bonds. Such an arrangement removes or minimizes the danger of extinction of the junior equity through default in bad times and thus permits the shoe-string common stockholder to maintain his position until prosperity returns. (But just becaus |
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