Chapter 11: Specific Standards for Bond Investment

7. The relation of stock capitalization to the funded debt: Graham suggests that this measure might not be very useful in practice as book valuations of fixed assets are highly unreliable indications of the safety of the bond. The main concern of the investor should be to ensure that the business is worth a great deal more than it owes. Since the worth of the business is tied to the earning power, he suggests an additional measure to reduce reliance on earnings as a measure of safety for bonds. He suggests using market value of capital stock to funded debt. Market value of stock issues is generally recognized as a better index of the fair going value of a business than is afforded by the balance sheet figures or even the ordinary appraisal. He is careful to note that the use of stock prices is for the restricted purpose of only ascertaining whether or not a substantial equity exists behind the bond issue.
• The utility of market price test in extreme cases is unquestionable. The presence of a stock equity with market value many times as large as the total debt carries a strong assurance of the safety of the bond issue and conversely, an exceedingly small stock equity at market prices must call the soundness of the bond into serious question.
• He suggests a minimum ratio of stock value to bonded debt (stock value ratio) of $1 of stock to $1 of bonds.
• No bond investment should be made if it requires the assumption that the common stock is selling too low at the time. If the investor is right in that judgment of the stock value, it would certainly be more profitable to buy the stock than the bonds. If he is wrong as to the stock value, he runs great risk of having made a poor bond purchase.