The Corporate Analysis And Investing
( Originally Published 1939 )
After having touched lightly upon the selection of the industry, the company, and its management, let's take as our hypothesis the Compass Motor Company and analyze it.
Our first step would naturally be the consideration of its corporate set-up. This should include all phases of its capitalization, such as preferred stock, common stock, bonds and debentures.
We find that the capitalization of the Compass Motor Company consists of preferred stock, common stock and bonds. In other words, the company expects, or should earn, an income upon the capital which these stocks and bonds represent. This capital represents the tools with which the company works, ranging from the intangibles of patents, to the concrete things of factory and equipment. Such items are known as the assets of a company.
Measured against these assets is the source from which the company derived the money to purchase them, and inasmuch as it is usually through stocks and bonds, the entire amount of out-standing stocks and bonds constitutes the liability side of the ledger. In other words, the company is liable for every outstanding share.
At any time the company, through its stockholders or directors, decides to increase the capitalization, that is, issue additional stocks or bonds, it increases its liabilities, and the income which the company anticipates must necessarily be distributed over a larger area.
The question arises, why has the Compass Motor Company both preferred and common stock, as well as bonds outstanding? It is possible that they started off with a capitalization representing nothing but common stock, but finding themselves in need of additional capital, they amended their charter to provide for the preferred stock, which, as will be later explained, has first preference over the assets and earnings.
In order to meet the demand for their product, they again find it necessary to raise more long-term capital for expansion purposes. They have two avenues open. One is to again increase the capitalization of their preferred and common, or else to market an issue of first mortgage bonds. These bonds have a guaranteed income, not dependent upon earnings, and represent a first mortgage on all of the Company's assets.
They may decide to issue bonds for two reasons. First, the expectation of the company is such, that they will be able to retire the bonds from earnings, thus in effect, having borrowed the money, used it as long as they wish, and then repaid it. As soon as they retire the bonds they have then decreased their capital liabilities.
Second, they may have experienced difficulty in raising additional capital through the sale of stock, and the only avenue left open is the placing of mortgages upon their entire properties.
Excessive capitalization should be avoided in all instances, whether it be common stock, preferred stock, or bonds. Each one of these obligations should yield an income, and they can only yield it through earnings.
In prosperous times excessive capitalization is seldom noticed by the average investor, but when hard times come, disastrous effects are the result. Companies find themselves forced to institute drastic capital readjustments to avoid financial disaster. The investor may then find his holdings cut in half, or even lower.