Fundamental Principles of Investment Valuation

Key Insight

The most reliable aspect of security analysis focuses on the safety and quality of bond issues and investment-grade preferred stocks. The primary criterion for corporate bonds is the historical coverage of total interest charges by available earnings, while for preferred stocks, it's the coverage of combined bond interest and preferred dividends. While specific standards vary, recommended minimums often involve average results over several years or a 'poorest-year' test. For instance, given higher interest rates, an alternative requirement relates to the percentage earned on the principal debt, such as 33% before taxes for industrial companies, 20% for public utilities, and 25% for railroads. Preferred stock coverage is calculated using earnings before income taxes relative to fixed charges plus twice the preferred dividends, accounting for the latter's non-deductibility.

Beyond earnings coverage, other factors contribute to bond and preferred stock safety. These include the size of the enterprise (e.g., minimum business volume or population for municipalities), the stock-to-equity ratio (market price of junior stock relative to debt), which indicates a 'cushion' against unfavorable developments, and, in specific cases like public utilities or real estate, property value. Investment history consistently shows that issues meeting stringent past-performance safety tests have largely navigated future challenges successfully. For example, railroad bonds with inadequate coverage historically failed, while those meeting strict tests often avoided financial distress, as evidenced by the Penn Central Railroad's collapse in 1970 after its fixed charges failed conservative standards by 1965. Similarly, soundly capitalized electric utilities have avoided receivership since Securities and Exchange Commission control.

Valuing common stocks ideally involves estimating average future earnings and applying an appropriate capitalization factor, which can vary widely based on the stock's 'quality'. Key considerations influencing this rate include general long-term prospects, though these market views can be fallible (e.g., chemical stocks with high multipliers in 1963 showed no earnings gain by 1970, while oils with lower multipliers performed better). Management quality is often reflected in past success and future estimates, and a recent change in management can be a significant factor, as seen with Chrysler Motor Corporation's dramatic turnaround in 1962, where earnings rose from $1.24 to $17 per share and price from $8.50 to almost $200 in a year. Other factors include financial strength and capital structure, with surplus cash and minimal senior securities being advantageous, and a consistent dividend record over many years, such as 20 or more, indicating high quality.