In this article we see the Security Analysis chapter 11 summary, In this summary, the author explains Criteria 7 of the Specific standard for bond investment, ( continued) so let’s talk about his criteria 7 i.e. Relation of Stock Capitalization to bonded debt.
Criteria- 7: Relation of Stock Capitalization to bonded debt:-Security Analysis chapter 11
so the question comes which thing of this criteria?
so this criterion is of principle 4 or principle 4 is of Bond selection, why do we talk about bond selection?
because we talk about Class-I security in this whole Part-II of this security analysis book.
so this above picture, you don’t have to be forgotten. (Security Analysis chapter 11)
so don’t go as deep as much that you forgot, what about we talk, and which part we talk.
Let’s start criteria -7
In this criteria, we found the ratio i.e. Stock Value ratio
Stock Value Ratio = Stock Equity / Bonded debt
so for this criteria, New York Status says:
This ratio is about 0.67 or 2/3rd of bonded debt or 67%
This means is, the capital stocks is minimum that of the bonded debt of 67% is minimum ( Capital Stock at least 2/3rd of bonded debt
so the question comes, like, should we use book value or Market Value of Capital stock?
for This, the Author says, ” Those are balance sheet figures, they are not dependable and they don’t give the right value of the property.”
In this ratio we use the Market Value of Capital stocks, but in this, the question is the Market Value is not stable, they depend on optimism and pessimism and they may be overvalued undervalued so this is our right doubt, but this market value is better than the book value and you get the rough index. (Security Analysis chapter 11)
And this is a supplement test but this is an important supplement test so interest coverage is not even you have to attach this one is also very important.
If this stock value ratio is more means the market value of equity is more than total debt, so this means this is a strong assurance the bond issue is safe. i.e. you want to buy that bond.
If stock Equity Market value is less, then you have to come with a question in your head i.e. why people are not ready to pay for that company and what problem in that company.
so the author gives some final requirement ratio for these three type companies like Public utilities, Railroad, Industrials
Bond Investment Interest coverage ratio Stock Value Ratio
1 ) Public Utility 1.75 1/2 or 50%
2) Railroads 2 2/3 or 66.67%
3) Industrials 3 1/1 or 100%
Another thing is The bonded debt is we have to buy on Par-value rather than Market Value.
Income bonds, we don’t have to be considered into bonded debt, or not in the interest coverage ratio, why this, because, Income bond is like preferred stocks, so on this, we can talk in the future chapter( when we talk about preferred stocks.)
Another thing is that those are jr. bonds for long-maturity they are like preferred stocks so there valvu you can include in stocks equity value.
so in these two situations come
- The earning coverage ratio of the company is not fulfilled by the minimum requirement but the stock value ratio fulfilled
- Another situation is the minimum requirement is fulfilled for interest coverage ratio and the stocks value ratio is not fulfilled.
The author gives examples,
In 1932, 33, they compare the two companies, Inland Steel and Crucible Steel.
some of their prices are as follows
ratios Inland Steel Crucible Steel
Coupon 4.5% 5%
Price 82 60
Yield 5.6% 13.6%
Coverage ratio 4.6X 7.1X
Stock Value Ratio 0.57 1.12
So Crucible Steel Company passes the interest coverage ratio and stock value ratios.
and failed by Inland Steel Company because 1 is required in the stock value ratio.
so Inland Steel is one of the best companies of their time, before the depression. (Security Analysis chapter 11)
In 1932, their earning goes down, but crucible steel, their earnings increases in depression also, the joking part is.
Crucible Steel, have both two ratios is more and the minimum requirement pass test or this yield is also high.
These are high-quality steel and they satisfy the interest coverage ratio and they provide more than double.
But actually, those companies are good and high-quality companies, so they provide the minimum yield because, in that the risk is less, and they are safe for bond investment in the senior bonds.
So in this Crucible Steel is safe and they provide the High Yield.
If Any investor buys the Inland Steel Instead of Crucible Steel, so the investor Assumes that
the first thing is they assume, this condition is temporary.
second thing is, they assume that the stock value ratio is less because the stock price is trading very fewer means in undervalued. (Security Analysis chapter 11)
another thing is they assume that crucible steel Value is Overvalued.
If you invest in any company don’t assume the above things.
Because, if you assume and you are not sure, then you don’t have to buy the bond.
Because you know that stock is undervalued then why do you buy bonds, you can directly buy the stocks, and make unlimited profits, and bonds have a limited return.
But, If this is just an assumption of the investor, so money is going wrong, then you have the loss of risk.
so Author is not speaking that Inland Steel is a bad Investment, at that time.
The author’s point of view is that The alternative means, Crucible is better than the Inland Steel.
so then you have to invest in that what the turnaround both of the result show you the right and wrong.
So the Actual result comes, after the depression,
is Inland Steel they repay the bond on 20 points of earning and their stocks are 4X.
so those authors talk about that stocks are undervalued, after depression, they prove.
Because, their stocks become 4X, so this type of investment is not just on the assumption, and not having your assumption is best. (Security Analysis chapter 11)
If you assume this company go high, they buy stocks,
In that time duration, Crucible steel bonds, and on 60 to 102, so this is also principle profits on buying bonds.
then the author says, the stocks Value ratio of industrial find out the easily but public utility and railroad is more complicated.
Like, those are bonded debt or other thing line or property of subsidiary, their ranking come first.
so those things of ranking come first then the company bond, then we have to these take expenses and add to them in bonded debt while finding out the ratio of Stock Value.
So on this, we can talk in the next Chapter on the railroad and Public utility
then the author says,” don’t modify the ratio to reflect changes in market condition.”
like the normal Market
Then for Industry Stock Equity Bonded debt
Normal $1 $1
Bull Market $2 $1
Bearish Market $0.5 $1
so for this reason, you don’t have to do this.
Because, the first reason is, those are bond buyers they don’t have the guts to tell high level or low level of Stock prices. (Security Analysis chapter 11)
If they are say higher level or lower level of stocks, then they have to invest in stock instead of bonds.
Other things, we assume, that those are bondholders, they give special attention on booming Market and When depression comes to their confidence increases.
So these are stupid things.
Because those are bond buyer, they are also human and when the booming time come, they also addict with booming and don’t leave that bullish craziness. and those are fear time comes, i.e. bearish
so no one escapes that also.
so this is human nature, not other things, but the difference, is that those are intelligent investors, they control this.
then the author says, ” This is stringent instead of relaxing or more stringent instead, you get the always any other security, so you just have to find out and they satisfy the normal test also.
and they don’t have to More strangest or not relax whatever the condition.
lastly, the author gives some stock value ratio, that image is posted on the telegram.
so this is all about the Security analysis chapter 11