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By Root 2858 0

them least reliable. For the more dependent the valuation becomes on anticipations of the future—and the less it is tied to a figure demonstrated by past performance—the more vulnerable it becomes to possible miscalculation and serious error. A large part of the value found for a high-multiplier growth stock is derived from future projections which differ markedly from past performance—except perhaps in the growth rate itself. Thus it may be said that security analysts today find themselves compelled to become most mathematical and “scientific” in the very situations which lend themselves least auspiciously to exact treatment.*

Let us proceed, nonetheless, with our discussion of the more important elements and techniques of security analysis. The present highly condensed treatment is directed to the needs of the nonprofessional investor. At the minimum he should understand what the security analyst is talking about and driving at; beyond that, he should be equipped, if possible, to distinguish between superficial and sound analysis.

Security analysis for the lay investor is thought of as beginning with the interpretation of a company’s annual financial report. This is a subject which we have covered for laymen in a separate book, entitled The Interpretation of Financial Statements. 2 We do not consider it necessary or appropriate to traverse the same ground in this chapter, especially since the emphasis in the present book is on principles and attitudes rather than on information and description. Let us pass on to two basic questions underlying the selection of investments. What are the primary tests of safety of a corporate bond or preferred stock? What are the chief factors entering into the valuation of a common stock?

Bond Analysis

The most dependable and hence the most respectable branch of security analysis concerns itself with the safety, or quality, of bond issues and investment-grade preferred stocks. The chief criterion used for corporate bonds is the number of times that total interest charges have been covered by available earnings for some years in the past. In the case of preferred stocks, it is the number of times that bond interest and preferred dividends combined have been covered.

The exact standards applied will vary with different authorities. Since the tests are at bottom arbitrary, there is no way to determine precisely the most suitable criteria. In the 1961 revision of our textbook, Security Analysis, we recommend certain “coverage” standards, which appear in Table 11-1.*

Our basic test is applied only to the average results for a period of years. Other authorities require also that a minimum coverage be shown for every year considered. We approve a “poorest-year” test as an alternative to the seven-year-average test; it would be sufficient if the bond or preferred stock met either of these criteria.

TABLE 11-1 Recommended Minimum “Coverage” for Bonds and Preferred Stocks

B. For Investment-grade Preferred Stocks

The same minimum figures as above are required to be shown by the ratio of earnings before income taxes to the sum of fixed charges plus twice preferred dividends.

NOTE: The inclusion of twice the preferred dividends allows for the fact that preferred dividends are not income-tax deductible, whereas interest charges are so deductible.

C. Other Categories of Bonds and Preferreds

The standards given above are not applicable to (1) public-utility holding companies, (2) financial companies, (3) real-estate companies.

It may be objected that the large increase in bond interest rates since 1961 would justify some offsetting reduction in the coverage of charges required. Obviously it would be much harder for an industrial company to show a seven-times coverage of interest charges at 8% than at 4½%. To meet this changed situation we now suggest an alternative requirement related to the percent earned on the principal amount of the debt. These figures might be 33% before taxes for an industrial company, 20% for a public utility, and 25% for a railroad. It should be borne in mind here