Summary:
The capitalization structure, dictating how a company allocates its total capital between senior securities and common stock, profoundly affects its overall valuation. To illustrate, consider three theoretical industrial companies: A, B, and C. While each company maintains an earning power of $1,000,000, their capitalization structures present unique configurations.
Company A's funding is derived exclusively from 100,000 shares of common stock, while Company B uses a blend of $6,000,000 in 4% bonds and 100,000 shares of common stock. Company C operates with $12,000,000 of 4% bonds and the same quantity of common stock as the others. If we assume that bonds are worth their face value and common stocks are priced at 12 times their per-share earnings, we can derive each company's value.
Hence, Company A is valued at $12,000,000, Company B at $15,000,000, and Company C at $18,000,000. This comparison underscores how identical earning powers can result in markedly different company values, due to differences in capitalization structures. However, it's essential to remember that these structures are determined voluntarily by the company's management.
This leads to an intriguing question: Can a company's value be influenced by adjusting the ratio of senior securities to common stock? To answer this, we must delve deeper into the assumptions behind our examples. If we operate on the premise that bonds are worth their face value and stocks are worth twelve times their earnings, we can argue that Company B's value is justifiable due to its sensitivity to earnings fluctuations. Yet, Company A's capital structure requires further scrutiny. A portion of Company A's common stock could be equated to Company B's blend of bonds and stock. As a result, some of Company A's stock should be valued at 4%, while the rest should be valued at 12 times earnings. Nevertheless, common stock buyers seldom acknowledge the existence of a "bond component" within a stock issue.
The theory of optimal capitalization structure proposes that a business should include senior securities up to the point they can be securely issued and purchased as investments. From a shareholder's perspective, assuming both bond issues are sound, Company B's capitalization structure is more attractive than that of Company A.
In recent times, many robust industrial corporations have shunned the issuance of new bonds and have retired old ones. This has resulted in a dearth of good industrial bond issues, impacting investors and investment policies in various ways. This trend has spurred an uptick in inferior bond issues and has funneled investors into the preferred stock field, fostering overall investor disillusionment and limiting investment options.
The valuation of Company C holds some inaccuracies as it relies on the premise that earnings, which are twice the interest charges, provide sufficient safety for industrial bonds. This assumption, however, doesn't hold true in all cases. Furthermore, an overabundance of bond issues can lead to a depreciation in the stock's value and heighten the possibility of financial turbulence. There are definite limits to the benefits that senior securities offer, and their value can become unstable when it surpasses a certain threshold.
Speculative capitalization structures may endow common stocks with a speculative edge, but they also render them susceptible to undervaluation in economic downturns. The case of American Water Works and Electric Company exemplifies how a speculative capitalization structure can sway stock value. From 1921 to 1929, the common stock value soared, far outstripping the relatively modest increase in earnings. This surge was largely attributed to an inflated valuation of per-share earnings and widespread enthusiasm for public-utility shares. Nevertheless, speculative capitalization structures can spur dramatic fluctuations in earnings and lower market prices, compared to more conservatively capitalized businesses.
In conclusion, the phasing out of senior securities in large corporations has boosted demand for common stocks, but it has also led to exorbitant prices and blurred the line between investment and speculation. An abundance of bond issues can depress the overall stock value, and speculative capitalization structures can render common stocks prone to undervaluation during downturns.
Investing in speculatively capitalized common stocks can prove profitable under certain conditions, but caution and sound judgment are paramount. Companies with a preponderance of their senior capital in preferred stock are preferable, as they help mitigate the risk of junior equity being wiped out in bad times. Yet, capitalizing on the full potential gain in these stocks can be tricky as prices continue to ascend. Investors must judiciously decide whether to hold for further gains or cash out to protect their current profits. On the whole, speculatively capitalized common stocks present both opportunities and challenges for investors.