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

its various implications.
    3 See Appendix Note 65, p. 820 on accompanying CD, for examples on this point.
    Overstatement of Earnings
. Holding companies can overstate their apparent earning power by valuing at an unduly high price the stock dividends they receive from subsidiaries or by including in their income profits made from the sale of stock of subsidiary companies.
    Examples:
The chief asset of Central States Electric Corporation was a large block of North American Company common on which regular stock dividends were paid. Prior to the end of 1929, these stock dividends were reported as income by Central States at the market value then current. As explained in our chapter on stock dividends, such market prices averaged far in excess of the value at which North American charged the stock dividends against its surplus and also far in excess of the distributable earnings on North American common. Hence the income account of Central States Electric gave a misleading impression of the earnings accruing to the company.
    A transaction of somewhat different character but of similar effect to the foregoing was disclosed by the report of American Founders Trust for 1927. In November 1927 American Founders offered its shareholders the privilege of buying about 88,400 shares of International Securities Corporationof America Class
B
Common at $16 per share. International Securities Corporation was a subsidiary of American Founders, and the latter had acquired the Class
B
stock of the former at a cash cost of $3.70 per share in 1926. American Founders reported net earnings for common stock in 1927 amounting to $1,316,488, most of which was created by its own stockholders through their purchase of shares of the subsidiary as indicated above. 4
    4 In the three years 1928–1930 the American Founders group reported total net investment profits of about $43,300,000; but all of this sum and more was derived from profits on intercompany transactions of the kind described above. See the S.E.C.’s Over-all Report on Investment Trusts, Part III, Chapter VI, Sections II and III, released February 12, 1940.
    Distortion of Dividend Return
. Just as a holding company’s income may be exaggerated by reason of stock dividends received, so the dividend return on its shares may be distorted in the public’s mind by payment of periodic stock dividends with a market value exceeding current earnings. People are readily persuaded also to regard the value of frequent subscription rights as equivalent to an income return on the common stock. Pyramided enterprises are prodigal with subscription rights, for they flow naturally from the succession of new acquisitions and new financing which both promote the ambitions of those in control and maintain speculative interest at fever heat—until the inevitable collapse.
    The issuance of subscription rights sometimes gives the stock market an opportunity to indulge in that peculiar circular reasoning which is the joy of the manipulator and the despair of the analyst. Company A’s stock is apparently worth no more than 25. Speculation or pool activity has advanced it to 75. Rights are offered to buy additional shares at 25, and the rights have a market value of, say, $10 each. To the speculative fraternity these rights are practically equivalent to a special dividend of $10. It is a bonus that not only justifies the rise to 75 but warrants more optimism and a still higher price. To the analyst the whole proceeding is a delusion and a snare. Whatever value the rights command is manufactured solely out of speculators’ misguided enthusiasm, yet this chimerical value is accepted as tangible income and as vindication of the enthusiasm that gave it birth. Thus, with the encouragement of the manipulator, the speculative public pulls itself up by its bootstraps to dizzier heights of irrationality.
    Example:
Between August 1928 and February 1929 American and Foreign Power Company common stock advanced from 33 to 138, although paying no dividend. Rights were offered to the common stockholders (and other security holders) to buy second preferred stock with detached stock-purchase warrants. The offering of these rights, which had an initial market value of about $3 each, was construed by many as the equivalent of a dividend on the common stock.
    Exaggeration of Book Value
. The exaggeration of book value may be effected in cases where a holding company owns most of the shares of a subsidiary and where