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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. Graham suggests there is an optimum capitalization structure.

·         He presents a hypothetical example of three companies, A, B and C each with an earning power of $1 million and are identical in each respects except the capitalization structure. Company A does not have any senior securities, Company B has a moderate debt and Company C has a large debt. The enterprise value (market value of stock and market value of bonds) of the three companies is likely to be different.

§  Company A is likely to be valued at a lower PE due to oversimplification of the capital structure. Investors not wanting such a bond component would be unwilling to pay extra for it.

s  This leads to an important principle: The optimum capitalization structure for any enterprise includes senior securities to the extent that they may safely be issued and bought for investment.

s  The above principle means that the contribution of the entire capital by the common stockholders may be called an over conservative setup, as it tends generally to make the shareholder’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 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.

§  Company B which is financed with an amount of debt that can safely be serviced has a higher enterprise value than Company A. Due to leverage Company B’s per share earnings are more responsive to an increase in aggregate earnings than Company A. While this also increases the sensitivity to a possible decline in profits, if an investor expects higher earnings in future – and presumably he selects his common stocks with this in mind – he would be justified in selecting an issue that will benefit more from a given degree of improvement.

§  Company C which has a large amount of debt would sell at a lower enterprise value than B, since the bonds are likely to be selling at a large discount to the face value as they are not safe. Thus there are definite limits upon the advantages to be gained by the use of senior securities. This advantage ceases at the point where their amount becomes larger than can safely be issued or bought for investment.

§  Thus Company A capitalization arrangement can be characterized as conservative, Company C speculative and Company B suitable or appropriate.

·         Speculatively Capitalized Stocks: 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 small increase in aggregate earnings may increase per share earnings by a large amount. Because of this there is some tendency of speculatively capitalized enterprises to sell at relatively high values in the aggregate during good times. Conversely, there 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.

§  Overdeflation of speculative issues in unfavorable markets creates the possibility of an amazing price advance when conditions improve, because the earnings per share then show so violent an increase.

§  In speculatively capitalized enterprise, the common stockholders benefit – or have the possibility of benefitting – at the expense of the senior security holders. The common stockholder is operating with a little of his own money and with a great deal of senior security holder’s money.

§  It would be easy to recommend the purchase of speculatively capitalized stocks when they are selling at abnormally low levels due to temporarily unfavorable conditions, but this assumes that the intelligent speculator can consistently detect and wait for these abnormal and temporary conditions. If this is 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.

§  More practically, the purchase of speculatively capitalized stocks must be considered under general market conditions that are normal. Assuming diversification and 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 commitments of this kind. In making such purchases, partiality should be shown to those companies in which most of the senior capital is in the form of preferred stock rather than bonds. Such a restriction removes or minimizes the danger of extinction of the junior equity through default in bad times and thus permits the stock holder to maintain his position until prosperity returns.

s  Since this benefits the common stock holder, it is clearly disadvantageous to the preferred stock holder.

There is a peculiar practical difficulty in realizing the full amount of prospective gain in any one of the purchases. As soon as a substantial profit appears, the holder is in a dilemma, because he can hold for a further gain only by risking that already accrued. Just as a convertible bond loses its distinctive advantages when the price rises to a point that carries it clearly outside of the straight investment class, so a common stock holder commitment is transformed into a more and more substantial commitment as the price continues to rise. An intelligent purchaser of Mohawk rubber at 15 could not have expected to hold it beyond 100, because at 100 the shares the distinctive characteristics of a speculatively capitalized junior issue.
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