This section is from the book "Business Finance", by William Henry Lough. Also available from Amazon: Business Finance, A Practical Study of Financial Management in Private Business Concerns.
We have already touched upon the fundamental reasons for regarding earning power as the proper basis of capitalization. This principle is generally accepted as correct in the United States, England, France, and other commercial countries except Germany, wherein the laws insist with much strictness on a close correspondence between capitalization and investment. Speaking on this point, Paul M. Warburg, now a member of the Federal Reserve Board, wrote several years ago:
Stock-watering, that is, capitalization of earning power or good-will, is permitted in England and France, while it is not allowed in Germany. While personally I prefer the German system, it is a mistaken idea to think that the capitalization of earning power necessarily means taking advantage of somebody. If the German sells at 200% an industrial stock paying 10% dividends, it amounts to the same as if the Englishman had sold at par twice the amount of shares on which 5% dividend is paid.*
* Quoted from article on "American and English Banking Methods Compared," by Paul M. Warburg, in North American Review, 1908.
Capitalization on the basis of earning power is not necessarily the result of a carefully thought-out plan. On the contrary, it usually is the by-product of an effort on the part of the managers of corporations to make their holdings as attractive as possible so as to be able to sell them at the highest possible price. It is for this reason that corporations which have shares that are actively dealt in are more generally capitalized on an earning power basis than are the corporations which are closely held. It has been found through long experience that shares which sell at or below par have a readier market and command a higher price in proportion to their yield than do shares which are quoted far above par. If a company is showing earnings of 40% on its common stock but is paying only small dividends, it will be found difficult, in all probability, to sell such shares at a price commensurate with their intrinsic value. But, if the same company through some device quadruples its capitalization so that the earnings on each share amount to 10%, it may safely be assumed that the new shares will sell for more than 25% of the market price of the old shares.
There is very little, if any, sound reason for the preference generally shown for shares that sell near or below par. Two explanations, however, may be. offered: First, there is a somewhat wider market for low-priced shares, due to the fact that they are usually bought and sold in lots of 10 or more; it is obvious that there are more people who can buy a lot of 10 shares worth $40 each, than a lot of 10 shares worth $400 each. Second, there is an impression in the mind of the average shareholder - a vague impression but powerful - that his stock either had or will have a real value about equivalent to its par value. If he buys below par, he sees a prospect, at least, of appreciation in the value of his holdings. This impression, we may grant at once, is based on a misconception. Many shareholders do not seem fully to understand that their property rights consist, practically, only of an equity, and that the corporation is under no obligations ever to return or account for the par value of their shares. Nevertheless, there is an imaginative appeal in the magic term "$100" stamped on the face of a stock certificate, which undoubtedly helps to sell low-priced shares.
The rate of capitalization of earning power of a corporation depends naturally on the corporation's stability and on the nature of the business. A railroad or public utility company may find stock which yields only 5 to 7% selling at or near par. The shares of a manufacturing or trading company must usually earn 8 to 12% or 15% if they are to sell at par. These percentages do not refer solely to dividends, but to the actual net earnings of the corporation after all claims prior to dividends on the common stock have been met. There is, of course, no definite rule for determining what percentage should or will be used in. working out the capitalization. That must be determined by observing the market action of the company's shares and of other similar shares.
There is a perceptible tendency, which it is. interesting to bear in mind, toward establishing an approximate equality between the outstanding capitalization of a company and its gross earnings. Note that the relation is with gross earnings, not with net earnings. When the F. W. Woolworth Company (owner of the well known chain of 5 and 10 cent stores) was incorporated in 1912, the estimated earning capacity was capitalized at $50,000,000, or over 80% of the entire capital stock. This figure was almost equivalent to the company's gross sales of the preceding year.
Following is a compilation showing the stocks and bonds outstanding in the hands of the public, the gross sales, and the percentage of gross sales to outstanding capitalization in each case:*
* Adapted from article in Wall Street Journal, August 26, 1915.
Gross to Capitalization
Pressed Steel Car.........
U. S. Steel.........
Republic Iron & Steel..........
It will be noted that the five companies at the bottom of the list above, had all been going- through a period of exceptionally slack business when this table was compiled. Ordinarily their gross would run a great deal higher. Making this allowance, we find only one radical exception in the above table to the general rule that capitalization and gross earnings tend toward an equality. This exception is the General Motors Company, the stock of which is selling at a high price; it is rumored that this company is likely to increase its capitalization at the first good opportunity.
The correspondence applies chiefly in manufacturing and trading operations and not at all in the railroad or public utility field. This may best be shown by the following tabulated comparisons of capital, gross returns, net returns, and percentage of net returns to capital, as shown by the United States Census returns for 1900, 1905, and 1910:
Net Returns to Capital
Net Returns to Capital
If we assume that the capital invested both in manufactories and in railroads is represented by an approximate equal market value of bonds and shares outstanding - which is, perhaps, not far from the truth - then the above figures give us the average rate of yield which the investor in the shares of railroad and of manufacturing companies may reasonably expect.
Although it is not possible to secure exactly corresponding data for other countries, it may be of interest to compare the above percentages with the yields on capital invested in various lines of business in Germany for the year 1908, which were as follows:*
Large Scale Chemical Enterprises.........
Mining, Smelting, Salt Works, etc..........
The average profits and dividends for various lines of industrials in Russia for 1911 were as follows: †
*"The German Great Banks," by Dr. J. Riesser, reprinted for the National Monetary Commission, Washington, 1911, p. 464.
† "Why Investments Pay in Russia," by Alexander Znamiecke, in The Americas, June, 1915.
The reason for the correspondence - or the tendency toward correspondence - in the two factors named above, which at first glance would be regarded as unrelated, is found in the fact that the percentage of net earnings to gross business tends to vary in inverse proportion to stability and in direct proportion to the risk of the business. This sounds like an extremely abstract and difficult proposition, though it is actually simple and practical. A company which is running a street railway system is engaged in a business that is well standardized and is subject to little risk as to fluctuation; consequently, there is a great deal of competition or potential competition among capitalists who are willing to put their money into the business, and the ratio of profits to gross earnings is reduced to a small percentage. On the other hand, the business of manufacturing a novelty which may quickly be displaced is risky, and capital will be invested only by persons who are experienced in the business. For both these reasons, the ratio of profits to earnings or sales must be exceptionally high in order to attract sufficient capital. The same factors precisely are at work in determining how large earnings must be in order to make the shares of various companies command a market price not far removed from their nominal value. The percentage of net profit on sales, and the percentage of yield on investments in the company's shares, will be about the same. Hence, it necessarily follows that capitalization tends to adapt itself and to become equal to gross business. It is perhaps unnecessary to repeat that this is only a tendency and by no means an invariable rule.
Many examples of the adjustment of capitalization to earnings might be cited; indeed, almost any large industrial corporation, the shares of which are widely traded in, would serve this purpose. At its reorganization, the United States Realty and Construction Company had tangible property worth approximately $11,000,000, and cash amounting to about $11,000,000, against which was issued $27,500,000 in preferred stock and $33,500,000 in common stock; $61,000,000 in all. The earning power of the two companies which had been combined amounted, however, to about $3,500,000, and there was thought to be reasonably good prospects for growth in these earnings. On the strength of these earnings the capitalization was regarded as perhaps somewhat excessive but not abnormal. As a matter of fact, the company later failed disastrously, due in part to the overestimates that had been made of its earning capacity.
A striking example of sudden variation in earnings quickly followed by readjustment of capital is furnished by the Submarine Boat Corporation. This corporation was originally known as the Electric Boat Company, and for many years was regarded as practically a failure. It had an authorized capital of $5,000,000 common and $5,000,000 preferred, of which $4,999,600 common and $2,667,500 preferred were outstanding. The company's business was to build submarines for which it held valuable patents, and also high-powered gasoline launches which may be used as submarine destroyers. After it appeared that the submarine was to become a highly important factor in the European conflict, it quickly became evident that the Electric Boat Company was in a position to reap enormous profits from the situation. As late as the winter of 1914, the common stock was quoted at a nominal price, around $10 a share; by the fall of 1915 it had risen to over $480 a share. During this rise, Isaac L. Rice, the organizer and long the chief manager of the company, sold his shares, which were taken over by a syndicate that arranged to recapitalize and for this purpose formed the Submarine Boat Corporation.
The shares of stock of the new corporation were issued without par value and for this reason it is impossible to cite exact figures showing the extent of the recapitalization.
However, on the basis of the quoted boat shares, the new capitalization of the Submarine Boat Corporation may be figured as having a market value at the beginning of $35,-000,000.
There is surely little doubt in the mind of any one who is familiar with such occurrences, as to the truth of the general statement that capitalization tends very strongly to conform itself to earnings rather than to actual investment.