Amazing articles on just about every subject...


The Common Stock

( Originally Published 1939 )



IN the vernacular of the stock market, possibly the stocks the average investor is principally concerned with, is that of common. It is the common stock which has laid the foundation for many fortunes, and at the same time has been the instrument in destroying many savings of a lifetime. It behooves us therefore to approach this type of stock with more than casual consideration.

First, what is a common stock? It can be said to. constitute the basic ownership of a company. It has no preference over any other stock, bond, or claim against the company, but after such preferred claims have been settled, then common represents the entire remaining interest in both assets and earnings.

Our first step in considering common stock is to determine its book value. How is this done? Let's assume that the Compass Motor Company has 1,000,000 shares of common outstanding, representing $5,000,000. Its surplus is $10,000,000 and its surplus-reserves are $2,500,000. Thus the total net worth of the company is $17,500,000. You determine the book value per share, by dividing the net worth of the company by the 1,000,000 shares outstanding, thus the book value is $17.50 per share.

No true status of the book value of the common stock can be determined, however, without a minute examination of what the surplus and surplus-reserves consist of. This subject, therefore, will be treated in a later chapter in the analysis of the balance sheet; but I would emphasize here against accepting surplus and surplus-reserve statements in the calculation of true book value, without determining in your own good opinion, as to the real and underlying value of such surplus. Suppose you find included in the surplus of the Compass Motor Company such items as patents, trade-marks, good will and other such intangibles. I would eliminate them completely from the surplus, before calculating the book value. True, such intangibles may be worth every dollar for which the company has set them up, but what are they worth in liquidation?

Now let's take the opposite side of the scale. Assuming that the company has no surplus, but is carrying a deficit of $1,000,-000. If you subtract your deficit from your $5,000,000 representing capital, you would then find only $4,000,000 available for 1,000,000 shares, or $4.00 per share.

Before going further, let's thoroughly recognize the principle that both surplus and deficit must be calculated on the balance sheet in their true light before you can accurately arrive at the real book-value. The plant that is worth $1,000,000 to a going concern, and will show on the balance sheet as such, may be worth only $250,000 in liquidation. And after all, common stock can only receive the residue after all prior claims have been paid.

The principle foundation upon which common stock rests, and which the investor is interested in, is earnings. A company which has a good earning record, over a period of years, will find such a record reflected in the market price of its stock.

To arrive at the amount of earnings per share, is to divide the amount available for common stock dividends by the number of shares outstanding. It must not be construed, however, that when you see published a specific amount available for common stock dividends, that it is always declared in dividends. It belongs to the stockholders undoubtedly, but, on the other hand, it is still in the discretion of the board of directors, as to how much and when it shall be declared.

Dividend policies often reflect the judgment of the management. Many companies, during the hectic years of depression, through which they successfully passed, can attribute having weathered the gale, in part, to the foresight of their management.

No wise board of directors will declare their entire earnings in dividends, and leave the company to face a possible financial crisis. The impatient investor, in a growing company, would do well to consider this.

Many young companies prefer to expand themselves through their earnings, that is, build up their properties, working capital and earning capacity. Unless they have reached a saturation point, this policy may be one of wisdom, and while cash dividends may be absent, nevertheless, the differential in the market price of the stock often proves more attractive than dividends. Some companies have gone for years without paying dividends, and at the same time have shown constant earnings, and their stock has enjoyed a very active market.

Some companies from time to time issue their dividends in stock. In doing this, it is principally a matter of bookkeeping. They merely transfer a portion of their surplus capital to their capital account, thus conserving their cash working capital, with no change in their assets.

The payment of dividends in scrip, also occurs at times. Scrip is like a promissory note of the company's, in which they agree to redeem the scrip, or pay the dividend which it represents at a later date.

Some investors use the earning barometer to measure the value of a stock. You often hear that such and such a stock is earning so many dollars per share, and that it should sell anywhere from ten to twenty times higher than its earnings per share, the exact number of times, usually depending upon who is writing or quoting the figures.

This principle is not always safe to use, but inasmuch as the market value of common stock usually depends upon the earnings of a company, it follows that some ratio necessarily exists. To find a safe ratio, therefore is important.

Do not confuse the dividends declared with the income earned. The percentage of the net earnings declared for dividend purposes varies with different companies. Some may have a policy of declaring sixty percent of their net earnings in dividends, others seventy, while still others only forty. Thus in buying stocks for in-come purposes determine the company's dividend policy. Irrespective of what percentage of earnings are declared, however, the market or sale value of its stock is usually reflected by its total net earnings.

While this rule is customary, it is an arbitrary one in the Street and cannot be accepted as a definite one to measure the true market value of stock. Many factors could enter into the market value of Compass Motor Company's stock besides earnings. The entire market might have a downward trend, with people liquidating instead of buying. Again the company's financial strength might appear weak, notwithstanding its earnings. Its pioneering stage may not have been passed, and many other physical as well as psychological considerations might enter into the picture.

If you do intend to use the earning ratio, however, a good plan would be to add the stock's high and low for the year and divide it by two. This would give you the average price for the year. Say, if the Compass Motor Company had a high of 12 and a low of 6 for the year, then the addition of the two would be eighteen. One-half of eighteen would show the year's average for the stock, i.e., $9.00 per share.

After having ascertained the average for the year, then multiply this average of $9.00 against the million shares outstanding. Thus you find that the total market value of their common stock for the year averaged $9,000,000.

You now find that the company had earnings of fifty cents per share for its common stock, or $500,000 for the year. Thus the stock, with an average price of $9.00 per share throughout the year, sold on a basis of 18 times its earnings. If you intend to rely on the earning ratio, I would suggest that you figure your high and low stock averages, and also earning averages, for a range of from four to six years.

There are so many factors entering into considering price ranges, against earnings, that the amateur investor may find it difficult. Even the more experienced don't rely upon it altogether. They merely use such statistical information as a further guide upon which to base their individual opinions.

The common-stockholder cannot lose more than his actual in-vestment, but he has this advantage over the preferred and bond holder; he can gain a great deal more. In prosperous times, when earnings are high, stock split-ups are frequent, sometimes as much as three, four and five to one. When such melons are cut, it naturally accrues to the common stockholders, the ones who basically own the company.

As stated before, while common stock owns the company, how-ever, its equity is not one hundred percent until the settlement of all prior claims, such as bonds, debentures, preferred stocks, accumulated dividends, etc.

Nevertheless, the spectacular rise and fall of many common stocks continues to justify the opinion that millions of investors would rather take their chances with this handicap, in an effort to reap a full and rich reward from their investments.



Home | More Articles | Email: info@oldandsold.com