Security Analysis : Sixth Edition, Foreword by Warren Buffett: Additional Aspects of Security Analysis. Discrepencies Between Price and Value

guarantee to take or place the shares.
    The new company had acquired the plant of the American Austin Car Company, which had started out in 1929 with $3,692,000 in cash capital and had ended in bankruptcy. The organizers of the Bantamenterprise bought in the Austin assets, subject to various liabilities, for only $5,000. They then turned over their purchase, plus $500 in cash, to the new company for 300,000 shares of its common stock. In other words, the entire common issue cost the promoters $5,500 cash plus their time and effort.
    The prospectus stated—what was an obvious fact—that the preference stock was “offered as a speculation.” That speculation could work out successfully only if the conversion privilege proved valuable, since the mere 6% return on a preferred stock was scarcely an adequate reward for the risk involved. (The character of the risk was shown clearly enough in the enormous losses of the predecessor company.) But note that before the conversion privilege could be worth anything, the common stock would have to sell for more than $3per share—and in that case the $5,500
investment of the organizers would be worth over
$1,000,000. In other words, before the public could make
any
profit, the organizers would have to multiply their stake 180
times
.
    Sequel
. By June 30, 1939, the company had accumulated a deficit of $750,000; it was compelled to borrow money from the R.F.C., and the preferred-stock holder no longer had any equity in current assets. The price of the preference stock declined to 3, but at the same time the common was quoted at ¾ bid. This meant (if the quoted price could be trusted) that, although the public had lost 70% of its investment, the organizers’ $5,500 contribution had still a nominal market value of $225,000.
    Example B: Aeronautical Corporation of America
, December 1939. This company offered to the public 60,000 shares of new common stock at $6.25 per share. The “underwriters,” who made no firm commitment to take any shares, received on the sale of each share the following three kinds of compensation: (1) 90 cents in cash; (2)of a share of stock, ostensibly worth 31 cents, donated by the principal stockholders; (3) a warrant to buy ½ share of stock at prices varying between $6.25 and $8.00 per share. If the common stock was fairly worth the $6.25 offering price, these warrants were undoubtedly worth at least $1 per share called for. This would mean an aggregate commission for selling effort of $2.34 per share, or more than one-third the amount paid over by the public.
    The company had been in business since 1928 and had been manufacturing its light Aeronca planes since 1931. Its business had grown steadily from $124,000 sales in 1934 to about $850,000 sales in 1939.However, the enterprise had been definitely unprofitable to the end of 1938, showing an aggregate deficit at that time of over $500,000 (including development expense written off). In 9½ months to October 15, 1939, it had earned $50,000. Prior to this offering of new shares to the public there were outstanding 66,000 shares of stock, which had a net asset value of only $1.28 per share. In addition to the warrants for 30,000 shares to be given the underwriters, there were like warrants for 15,000 shares in the hands of the officers.
    There seemed strong reason to believe that the company occupied a favorable position in a growing industry. But analysis would show that the participation of the public in any future increase in earnings was seriously diluted in three different ways: by the cash selling expense subtracted from the price to be paid for the new stock, by the small tangible assets contributed by the original owners for their stock interest and by the warrants which would siphon off part of any increased value. To show the effect of this dilution, let us assume that the company proves so successful that its fair value is twice its tangible assets after completion of this financing—say, about $1,000,000 as compared with $484,000 of tangible assets. What could then be the value of the stock for which the public paid $6.25? If there were no warrants outstanding, this value would be about $8 per share on 126,000 shares. But allowing for a value of say $2.00 per share for the warrants, the stock itself would be worth only $7.25 per share. Hence even a very substantial degree of success on the part of this enterprise would add a mere 16% to the value of the public’s purchase. Should