Financial Structure and Dollars Per Share

This department is designed to help readers to a better understanding of the general business conditions which affect their investments. It is obviously impossible to give advice as to specific investments.

by HOWARD DOUGLAS DOZIER

THE investing of money is the buying of income. One who refuses to accept this proposition as a working hypothesis or whose mind is incapable of thinking in terms of it can hardly qualify as an investor. He may be a speculator, to be sure, and that is his own lookout. If he is, he has less than one chance in fifty of saving his skin.

In the Financial Counselor columns of the Atlantic for February, I used the relative amounts of interest and of dividends purchasable with a hundred dollars of investment as a thermometer for measuring speculative fever, as a sort of indicator of the ripeness of the time when an investor, as distinguished from a speculator, might with propriety transfer funds from bonds to stocks, or from stocks to bonds. It was there pointed out that had one followed the rule of thumb of selling stocks and buying bonds when a dollar in the dividends of a corporation cost as much as a dollar in its interest, and of selling bonds and buying stocks when a hundred dollars of investment money would buy something over two dollars more of dividends than of interest, he would have been far more successful in preserving his income, and therefore his principal, than most people, even those in high places, have been. I was very careful to point out, however, that even after an investor has arrived at the general conclusion that the time has come to do something, he is still confronted with the question of what to do, what bond or what stock to buy. In this paper I hope to point out certain considerations of primary importance which must be taken into account when one gets down to these brass tacks.

Inasmuch as it now seems that the next logical shift of investment is going to be from bonds to stocks, I am assuming here that this is so, and that the investor would do well to begin now to pick out a good landing place — that is, begin selecting a small list of stocks into some of which he may later turn the proceeds of his bond sales.

It goes without saying, of course, that one who is looking for good common stocks into which he may put his money will first of all make a study of the industries in which the corporations whose stocks arc under investigation are engaged. Assuming that such an investigation has been made and a determination reached with respect to the industries themselves, the next step is to dissect the corporations in order to see their inward parts.

There are certain glib phrases which pass currently as financial philosophy. The more conservative investors should take with a grain of salt and the less conservative with a whole spoonful some of these which purport to be infallible in determining what a stock is worth. Here is one of them: ‘Stocks are worth ten times their earnings.’

There may be some truth in this when it is applied very roughly to stocks generally, but people do not buy cross sections of the stock market. For the most part they buy a few shares, and the majority of them a very few, in still fewer corporations. When the time comes to plank down hard cash in return for the common stock of a specific corporation, something far less platitudinous and vague is needed than a general statement about a price-earnings ratio.

The starting point for a specific analysis of the common stock of a corporation is the corporation’s financial structure. But what is a financial structure, and how does it figure in aiding one at the time for decisive action? An illustration may be more illuminating than an attempt at a formal definition.

Let us take two corporations engaged in the same industry and precisely alike in all respects save in the financial structure under which they operate, and compare the position of the common stockholders under two assumed different financial structures: —

CORPORATION A

First-mortgage 5% bonds, $1,000,000

30,000 shares common stock 3,000,000

Total capitalization $4,000,000

CORPORATION B

First-mortgage 5% bonds $1,000,000

Second-mortgage 6% bonds 2,000,000

10,000 shares common stock 1,000,000

Total capitalization. $4,000,000

These two financial structures have been made very simple purposely, and one of them has been made topheavy with bonds in order to illustrate my point. The financial structure of Corporation A consists of one fourth bonds and three fourths common stock. That of Corporation B consists of two classes of bonds which make up three fourths of its total capitalization, and one fourth common stock. In the second of these financial structures recognition has been given to the wellknown and generally accepted fact that as a property becomes more heavily bonded both the principal of the bonds and likewise the interest become less certain and the interest rate becomes higher.

Suppose these two corporations operate successfully throughout a year and earn the same amounts. Let us observe how the common stockholders of each corporation would fare under the equal earnings that year, and then under earnings of one half that amount in another.

If in the first year each has a net operating income of $400,000, — that is, what is left out of gross revenue after paying all operating expenses, taxes, carrying a proper amount into depreciation reserve, and paying all other expenses properly chargeable against the business, — Corporation A would be able to pay its bondholders their $50,000 in interest and would have left for the owners of the SO,000 shares of common stock $350,000 or $11.67 per share. This $350,000 the directors, at their discretion, could pay out in whole or in part as common dividends, or could retain in the business in the form of a surplus which would increase the stockholders’ equity in the business.

Out of a like net operating income of $400,000, Corporation B could pay the first-mortgage bondholders the $50,000 due them and the second-mortgage bondholders the $120,000 due them. These payments would amount to an interest charge, all told, of $170,000, which would leave for the owners of the 10,000 shares of stock $230,000 or $23.00 per share.

Now the blind following of the lip-worn phrase whose validity we are testing — namely, that stocks are worth ten times their per share earnings — would place a value of $116.67 per share oil the common stock of Corporation A and one of $230.00 a share on that of Corporation B. This is a little startling, but let us not go too fast. Before drawing any rash conclusions as to the superiority of the common stock of Corporation B over that of Corporation A, let us test the lusting qualities of these corporations under a little adversity.

With a net operating income of $200,000, which is just one half that used under our first assumption, Corporation A could pay its interest of $50,000 and have left for the owners of its 30,000 shares of common stock $150,000, which is $5.00 per share. Corporation B could still pay the interest on both classes of its bonds, — namely, $170,000, — but would have left for the owners of its 10,000 shares of common stock only $30,000, or $3.00 per share. Again, a ruthless application of a price-earnings ratio of ten would place a value of $50.00 a share on the common stock of Corporation A and $30.00 a share on that of Corporation B.

Your price-earnings devotee will tell you that a decline in earnings of 50 per cent, in the case of these corporations, has brought about a decline in the stock of Corporation A from $116.67 to $50.00, and that a like falling off in earnings has caused the common stock of Corporation B to fall from $230.00 a share to $30.00 a share. This seems a little too pessimistic. If it had so happened that the net operating income had increased from $200,000 to $400,000, the statement of the case would have been that a doubling in earnings resulted in a little more than a doubling in the price of the common stock of Corporation A and an almost eight-fold increase in the price of the stock of Corporation B. This is altogether too optimistic and the whole smacks a little too much of mathematical finality. There is a place in the picture somewhere for the exercise of ordinary common sense.

There are some generalizations which can be drawn from the per share earnings as shown in these illustrations, but they do not have to do primarily with the price of the stock. That is incidental. They have to do with the choice by an investor as between two corporations whose financial structures are here typified. The per share earnings of a corporation most of whose financial structure consists of common stocks are less variable than the per share earnings of another equally good corporation whose financial structure is in small part common stock. A corollary to this is that the price of the common stock of a corporation with the former type of financial structure is less sensitive than the price of the stock of a corporation of the latter type of structure.

Inasmuch as the investor is primarily interested in the quality of income, and then in its quantity, he will naturally prefer to put his money into the common stock of those corporations whose financial structure is mainly common stock, provided, of course, that the corporations are about equal in all other respects.

Not so your speculator; he dotes on price fluctuations rather than on income. If he cannot discover price fluctuations he tries to invent them and turns naturally to the type of stock most sensitive, not only to earnings, but also to rumor. So long, therefore, as the investor stays by those good common stocks of corporations whose financial structure is mostly common stock, he not only enjoys the stability inherent in them, but he avoids the variability and uncertainty inherent in the common stocks of corporations whose financial structure is in small part stocks and the additional instability brought about artificially by speculators seeking a medium for their daily operations.

Thus the owning of common stock in a good corporation whose financial structure is mainly or wholly common stock aids the investor in his efforts to obtain an income which is as large as possible, consistent with certainty, uniformity, and continuity.