The Intelligent Investor_ The Definitive Book on Value Investing - Benjamin Graham [169]
Let us consider for a moment what is really involved in this financial setup. Ordinarily, a common-stock issue has the first right to buy additional common shares when the company’s directors find it desirable to raise capital in this manner. This so-called “preemptive right” is one of the elements of value entering into the ownership of common stock—along with the right to receive dividends, to participate in the company’s growth, and to vote for directors. When separate warrants are issued for the right to subscribe additional capital, that action takes away part of the value inherent in an ordinary common share and transfers it to a separate certificate. An analogous thing could be done by issuing separate certificates for the right to receive dividends (for a limited or unlimited period), or the right to share in the proceeds of sale or liquidation of the enterprise, or the right to vote the shares. Why then are these subscription warrants created as part of the original capital structure? Simply because people are inexpert in financial matters. They don’t realize that the common stock is worth less with warrants outstanding than otherwise. Hence the package of stock and warrants usually commands a better price in the market than would the stock alone. Note that in the usual company reports the per-share earnings are (or have been) computed without proper allowance for the effect of outstanding warrants. The result is, of course, to overstate the true relationship between the earnings and the market value of the company’s capitalization.*
The simplest and probably the best method of allowing for the existence of warrants is to add the equivalent of their market value to the common-share capitalization, thus increasing the “true” market price per share. Where large amounts of warrants have been issued in connection with the sale of senior securities, it is customary to make the adjustment by assuming that the proceeds of the stock payment are used to retire the related bonds or preferred shares. This method does not allow adequately for the usual “premium value” of a warrant above exercisable value. In Table 16-4 we compare the effect of the two methods of calculation in the case of National General Corp. for the year 1970.
Does the company itself derive an advantage from the creation of these warrants, in the sense that they assure it in some way of receiving additional capital when it needs some? Not at all. Ordinarily there is no way in which the company can require the warrant-holders to exercise their rights, and thus provide new capital to the company, prior to the expiration date of the warrants. In the meantime, if the company wants to raise additional common-stock funds it must offer the shares to its shareholders in the usual way—which means somewhat under the ruling market price. The warrants are no help in such an operation; they merely complicate the situation by frequently requiring a downward revision in their own subscription price. Once more we assert that large issues of stock-option warrants serve no purpose, except to fabricate imaginary market values.
The paper money that Goethe was familiar with, when he wrote his Faust, were the notorious French assignats that had been greeted as a marvelous invention, and were destined ultimately to lose all of their value—as did the billion dollars worth of American & Foreign Power warrants.* Some of the poet’s remarks apply equally well to one invention or another—such as the following (in Bayard Taylor’s translation):
TABLE 16-4 Calculation of “True Market Price” and Adjusted Price/Earnings Ratio of a Common Stock with Large Amounts