Sunday, September 24, 2006

Ideas of Graham and Dodd Part VI (Current Asset and Cash Asset Values)


Page 537

Allowances for Changes in Capitalization

In dealing with the past record of earnings, when given on a per-share basis, it is elementary that the figures must be adjusted to reflect any important changes in the capitalization which have taken place during the period. In the simplest case these will involve a change only in the number of shares of common stock due to stock dividends, split-ups, etc. All that is necessary then is to restate the capitalization throughout the period on the basis of the current number of shares.

Page 540

The intrinsic value of a common stock preceded by convertible securities, or subject to dilution through the exercise of stock options or through participating privileges enjoyed by other security holders, cannot reasonably be appraised at a higher figure than would be justified if all such privileges were exercised in full.

Page 543

Principle of Optimum Capitalization Structure

The optimum capitalization structure for any enterprise includes senior securities to the extent that they may safely be issued and bought for investment.

Part VI of the Book


Page 567

By way of introduction to this section of our work, let us list five types of information and guidance that the investor may derive from a study of the balance sheet:

It shows how much capital is invested in the business.
It reveals the ease or stringency of the company’s financial condition, i.e., the working-capital position.
It contains the details of the capitalization structure.
It provides an important check upon the validity of the reported earnings.
It supplies the basis for analyzing the sources of income.

The book value per share of a common stock is found by adding up all the tangible assets, subtracting all liabilities and stock issues ahead of the common and then dividing by the number of shares.

In addition to the well-known concept of book value, we wish to suggest two others of similar character, viz., current-asset value and cash-asset value.

The current-asset value of a stock consists of the current assets alone, minus all liabilities and claims ahead of the issue. It excludes not only the intangible assets but the fixed and miscellaneous assets as well.

The cash-asset value of a stock consists of the cash assets alone, minus all liabilities and claims ahead of the issue.

Page 576

In any particular case the message that the book value conveys may well prove to be inconsequential and unworthy of attention. But this testimony should be examined before it is rejected. Let the stock buyer, if he lays any claim to intelligence , at least be able to tell himself, first, what value he is actually setting on the business and, second, what he is actually getting for his money in terms of tangible resources.

There are indeed certain presumptions in favor of purchases made far below asset value and against those made at a high premium above it.

A business that sells at a premium does so because it earns a large return upon its capital; this large return attracts competition, and, generally speaking, it is not likely to continue indefinitely.

Page 577
It may be pointed out that under modern conditions the so-called ‘intangibles,” e.g., good-will or even a highly efficient organization, are every whit as real from a dollars-and-cents standpoint as are buildings and machinery. Earnings based on these intangibles may be even less vulnerable to competition than those which require only a cash investment in productive facilities.

We do not think, therefore, that any rules may reasonably be laid down on the subject of book value in relation to market price, except the strong recommendation already made that the purchase know what he is doing on this score and be satisfied in his own mind that he is acting sensibly.

Page 578

The current-asset value is generally a rough index of the liquidating value.

Page 581

Our computations indicate that over 40% of all the industrial companies listed on the New York Stock Exchange were quoted at some time in 1932 at less than their net current assets. A considerable number actually sold for less than their cash-asset value.

In the recession of 1937-38 this situation was repeated on a smaller scale. Available data indicate that 20.5% of the industrial companies listed on the New York Stock Exchange sold in early 1938 at less than their net-current-asset value. (At the close of 1938, when the general price level was by no means abnormally low, a total of 54 companies out of 648 industrials studied sold for less than their net current assets.)

Page 583

Stocks selling below liquidation value are in many cases too cheap and so offer an attractive medium for purchase. We have thus a profitable field here for the technique of security analysis. But in many cases also the fact that an issue sells below liquidating value is a signal that mistaken policies are being followed and that therefore the management should take corrective action-if not voluntarily, then under pressure from the stockholders.

Page 587

There is scarcely any doubt that that common stocks selling well below liquidating value represent on the whole a class of undervalued securities. They have declined in price more severely than the actual conditions justify. This must mean that on the whole these stocks afford profitable opportunities for purchase. Nevertheless, the securities analyst should exercise as much discrimination as possible in the choice of issues falling within this category. He will lean toward those for which he sees a fairly imminent prospect of some one of the favorable developments listed above (Page 583). Or else he will be partial to such as reveal other attractive statistical features besides their liquid-asset position, e.g., satisfactory current earnings and dividends or a high average earning power in the past. The analyst will avoid issues that have been losing their current assets at a rapid rate and show no definite signs of ceasing to do so.

Page 583

The objection to buying these issues (*issues selling below current asset value - liquidating value) lies in the probability, or at least the possibility, that earnings will decline or losses continue and that the resources will be dissipated and the intrinsic value ultimately become less than the price paid. It may not be denied that this does actually happen in individual cases. On the other hand, there is a much wider range of potential developments which may result in establishing a higher market price. These include the following:

The creation of an earning power commensurate with the company’s assets. This may result from:
1. General improvement in the industry.
2. Favorable change in the company’s operating policies, with or without a change in management. These changes include more efficient methods, new products, abandonment of unprofitable lines, etc.
3. A sale or merger, because some other concern is able to utilize the resources to better advantage and hence can pay at least liquidating value for the assets.
4. Complete or partial liquidation.

Page 589

Common stocks that (1) are selling below their liquid-asset value, (2) are apparently in no danger of dissipating these assets, and (3) have formerly shown a large earning power on the market price, may be said truthfully to constitute a class of investment bargains. They are indubitably worth considerably more than they are selling for, and there is reasonably good chance that this greater worth will sooner or later reflect itself in the market price. At heir low price these bargain stocks actually enjoy a high degree of safety, meaning by safety a relatively small risk of loss of principal.

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