Hello friends in today’s article, we see chapter 12 of the Security analysis book. In this chapter, we see a special factor in the Analysis of Railroad and Public-Utility companies. so let’s start with Railroad Bond analysis.
Railroad Bond Analysis:-Security Analysis: Chapter 12
so let’s, in this
The authors said, ” those are railroad companies they have maximum data. so those are individuals who have the competency to analyze data correctly.
The author also, says, ” if we have to do high-grade bond analysis, then why we invest in this bond, instead
we can invest in stocks, with that much analysis, which means, there are no more benefits of analysis when we invest in the high-grade bond.
Just we have to keep remember is that those are income generating, they are more above the interest charges means good interest coverage ratios. (Security Analysis: Chapter 12)
so another thing, is that those are stock value ratio is also high.
Then the author talks about the railroad industry general things like
those are light traffic, they go in the truck, and those are passenger traffic they go in their own car.
so only heavy traffic remains for Railroad, traffic like, Coal, iron steal, mineral transport.
so railroad success, depends on this thing also, that much increases then profit increases.
and another also quantitative part is an available book, if you want to learn, more about the railroad, then buy the book from the following link
so let’s start with Public Utility company bond analysis
Public Utility Bond Analysis:-Security Analysis: Chapter 12
In public utility bond analysis have three problems, they are as follows
1 ) People think, the application of the term of the public utility to on industrial operations.
so this is not the right thing, for the right things, we have to define and understand the public utility definition.
Public utilities are those types of companies that are providing essential services under government regulation and the most important thing is on public utility is ‘ they are stable and have legal right to charge that much to be a profitable and good return on capital investment.
stability means,
They are relatively stable with other companies in the same industry.
then the author says,” Nowadays, pseudo Utility comes more like, selling ice, operating taxi cabs, owning cold storage plant. so people also called, then also public utility.
So this is the first problem,
so these are actually industrial operations but they mean people called them a public utility.
Nowadays their combination come( 1933)(author talk in 1933, don’t forget that)
like, Natural gas is combined with Ice Plant. (Security Analysis: Chapter 12)
2) the second problem is that this one bond issue whatever their prospective they use the prior-deductions method to calculate interest coverage ratio.
we lastly talk about this method, is they are a useless method, we have to use total method.
This problem is that those are junior bond issues, they are more covered properly as compare to senior bond issues.
If you apply common sense, you see these are nonsense things.
3) the third problem is that companies do not include the depression charges, while considered or finding interest coverage ratio. if they may be understated depression or not include then.
If someone says, your depreciation is the only bookkeeping thing concept, then your money is not spent properly.
then it means, that if you listen then or agree with them, that means they make you fools or you become a fool by them.
Depression is important and you have to subtract them, because, your instruments use daily, and their value becomes less sometimes later they become obsolete.
So that instruments losing their power by using daily, for that we have to subtract depreciation and other problem is unstable in this problem, the author says,
minimum 10% of gross revenue and 4% of total profit value, that much have to subtract.
If you want to be more conservative, then you can take 12% of gross revenue as a minimum.
4) there is the fourth problem is that
those are Federal taxes are imposed after deduction interest.
How you can find, = EBIT/interest expenses
But most of the time, those are corporate people, in their reports, they deduct the tax first, and then show the earning, and then coverage ratio is found. (Security Analysis: Chapter 12)
So you don’t give the tax paid first, so in this, you don’t worry about from where I am and add tax and earning the become minimum.
So this is a good thing, you have become more conservative and you take past then actual earning, so this is no problem.
because they don’t give any big difference by adding tax.
But if you analysis of a Holding company bond, then, you have to worry about some
So those are holding company they have to pay subsidiaries and their subsidiaries bond issues and preferred stocks payments.
So holding company, first have to pay their subsidiaries preferred stocks or bond issues, and after that holding companies bond issues charges.
so in this, we have to consider the tax.
Those are preferred dividends, you have to pay to subsidiaries and tax on them and after whatever earnings come, you can use it. (Security Analysis: Chapter 12)
Then the author gives the Example, How a company fools the Investor.
How a company Fools the Investor:
The companies debenture Issues, they have price is about $3,000,000
and companies business is, this company operate 20 telephone companies and 4 ice companies.
Value of property = $12,500,000
After depreciation, this value is equal to $1650 per $1000 bond issues after deduction of prior obligations.
so following are the income account.
Gross earnings – $3,361,000
Net Before Depreciation – $969,000
Prior Deductions – $441,000
Balance for Debentures – $528,000
interest on Debentures – $195,000
Balance for Stocks – $ 333,000
the Balace is above 2.71 X(times) interest on this issues.
so how they found this,
so Coverage ratio= Debentures balance / Interest of debentures
coverage ratio = $528,000 / $195,000
coverage ratio = 2.71X
the question arises
What is the problem with these ratios
so the first problem in this is as follows
1) Business combined means, the actual utility is mixed with industrial operations but they are ice plants. (Security Analysis: Chapter 12)
and they don’t give the gross and net income of ice plants
we don’t know how much percentage from the ice plant and how much percent from the telephone company.
so they don’t give us
if we assume ice business give maximum percentage income, that’s why they try to hide this.
second problem
2) the second problem is Depreciation is not subtracted.
Those are other telephone companies whose 15% of gross revenue is the depreciation.
so,
If we take 15% of depreciation = 15% of $3,361,000
depreciation = $ 500,000
If we take Net income after depreciation = $969,000 – $500,000
Net Income = $ 469,000
and then we take calculations as follows, we get the result
Balance for debentures = $ 469,000 – $441,000
Balnce for debentures = $ 28,000
and Interest on debentures = $ 195,000
so they are not equal to the debentures
this is the trick
so if we can not assume $500,000 depreciation, Because, those are ICE plants, their depreciation is very less.
so we can assume depreciation as $300,000 ( i.e. 9th 1/2 % of Gross revenue.)
third problem
3) Third Problem is that they used the prior- Deductions method.
In this we get the debentures safety
Debentures safety = $ 528,000 / $195,000
Debenture safety= 2.71X
and If we see for the senior bond issue, we get as follows
Senior bond safety= $969,000 / $441,000
Means Senior Issue is less secured and Debenture issues is more secure(junior bond issues)
So this is not a logical thing, as compared to the seniority (Security Analysis: Chapter 12)
If we make the right income account is as follows
Restating property:
Gross Earnings – $3,361,000
Net before Depreciation – $969,000
Depreciation – $ 300,000
Balance for Interest – $669,000
Total Interest Charges – $441,000 + $195,000
Total Interest charges – $636,000
Coverage Ratio – $669,000 / $636,000
Coverage Ratio – 1.05X
so forth problem
4) So fourth problem is that,
they say, $1650 of property value behind each $1000 debentures
so given,
Property Value – $12.5 million
Total Debt – $ 10.5 Million
Senior debt – $7.5 Million
Debentures – $ 3 million
so how much actual coverage ratio, we get
let’s find it out
for that,
Calculations:
property Value / Total Debt = $ 12.5 M / $10.5 M = 1.19
( M denote here – Millions)
It means only, i.e. $1190 of property value behind $1000 of total Debt.
so what companies say, How they get see following calculations
where they misguided ( mistake) (Security Analysis: Chapter 12)
Property Value for Debentures = $ 12.5 M – $ 7.5 M
Property Value for debentures:- $ 5 M
Debentures = $ 3 M
Property / total Debt = $ 5 M / $ 3 M
so that why come $ 1650
so in this time, they used the prior deductions method ( that method secure junior) to fool investor
if we apply for senior, then they are $ 1400 of property value behind each $1000 of senior debt.
Means Senior is less safe if we see the only a number
so this type, Companies make fool to investor
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