Personal Finance & Money Asked on March 12, 2021
I am reading The Intelligent Investor, and the follow quote doesn’t make total sense to me:
An industrial company’s finances are not conservative unless the common stock (at book value) represents at least half of the total capitalization, including all bank debt. For a railroad or public utility the figure should be at least 30%
First, I don’t get what "common stock (at book value)" means. I know what common stock is, and I know what book value is. But what does the phrase "common stock at book value" mean?
Second, he talks about ‘total capitalization’. I wasn’t sure exactly what that was, and looked it up. Is this article the correct definition in context with this excerpt?
Market Capitalization
Another aspect of capitalization refers to the company’s capital structure. Capitalization can refer to the book value of capital, which is the sum of a company’s long-term debt, stock, and retained earnings.
The alternative to the book value is the market value. The market value of capital depends on the price of the company’s stock. It is calculated by multiplying the price of the company’s shares by the number of shares outstanding in the market. If the total number of shares outstanding is 1 billion and the stock is currently priced at $10, the market capitalization is $10 billion. Companies with a high market capitalization are referred to as large caps; companies with medium market capitalization are referred to as mid caps; and companies with small capitalization are referred to as small caps.
It is possible to be overcapitalized or undercapitalized. Overcapitalization occurs when earnings are not enough to cover the cost of capital such as interest payments to bondholders, or dividend payments to shareholders. Undercapitalization occurs when there’s no need for outside capital because profits are high and earnings were underestimated.
Source: Capitalization on Investopedia
If you want to see the full context of the section, it is page 122 of this version of The Intelligent Investor: https://www.e-reading.club/bookreader.php/133361/The_Intelligent_Investor.pdf
Thanks in advanced for any input!
When people use non-standard terms to refer to pretty standard concepts, they are likely looking to appear as the sole authority on the topic, rather than one of many sources you could be learning from.. Using standardized terms reduces the above to the following:
"An industrial company should have a debt:equity ratio of 1:1 or less."
ie: They should be funded by, at most, 50% debt, with the remaining financing having come from equity (shares).
It seems this book in particular is 70+ years old, meaning the wording choice may have been standard at the time. This just raises the issue that using rules of thumb at all can be misguided, but using them from nearly a century ago, is likely even worse (e.g. considering Railroads a noteworthy category of 'industry').
Answered by Grade 'Eh' Bacon on March 12, 2021
We have to do a little detective work, and even then we may not get Graham's definition completely right. Starting with your Investopedia link, total capitalization is defined as:
Capitalization can refer to the book value of capital, which is the sum of a company's long-term debt, stock, and retained earnings.
Let's look at AT&T's total capitalization as of 12/31/2020, in three parts as Investopedia has them: From the balance sheet, Long-Term Debt and Capital Lease Obligations are $176 billion, Stock (preferred, common and additional paid-in capital, minus treasury stock (which I understand to be the opposite of paid-in capital)) is $120 billion, and Retained Earnings are $37 billion. In sum, total capitalization is $333 billion.
Graham's ratio for the defensive investor is the book value of common stock to total capitalization. For AT&T, the Stock amount has little or no preferred stock component, so I will use it as the book value of common stock. $120 billion / $333 billion = 36%
Thus AT&T today does not meet the ratio (50%) appropriate for a defensive investor.
Answered by Orange Coast- reinstate Monica on March 12, 2021
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