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

as to include factors or results that are totally out of date. The six years 1934–1939 might well be regarded as a somewhat better criterion, for example, than the longer period 1933–1939.
    Figures relating to preferred stocks fall into two different classes, depending on whether the issue is considered for fixed-value investment or as a speculative commitment. (Usually the market price will indicateclearly enough in which category a particular issue belongs.) The items marked “I.P.” are to be used in studying an investment preferred stock, and those marked “S.P.” in studying a speculative preferred. Where there are junior income bonds, the simplest and most satisfactory procedure will be to treat them in all respects as a preferred stock issue, with a footnote referring to their actual title. Such contingent bond interest will therefore be excluded from the net deductions or the fixed charges.
    In this tabular comparison we follow the suggestion previously offered that the effective debt be computed by capitalizing the larger of net deductions or fixed charges. In using the table as an aid to the selection of senior issues for investment, chief attention will be paid to items 22 and 23 (or 22 “I.P.” and 23 “I.P.”), showing the average margin above interest (and preferred dividend) requirements. Consideration should be given also to items 6, 7 and 8, showing the division of total capitalization between senior securities and junior equity. (In dealing with bonds, the preferred stock is part of the junior equity; in considering a preferred stock for investment, it must be included with the effective debt.) Items 10 and 19 should also be examined to see if the earnings have been overstated by reason of inadequate maintenance or by the inclusion of unearned dividends from subsidiaries.
    Speculative preferred stocks will ordinarily be analyzed in much the same way as common stocks, and the similarity becomes greater as the price of the preferred stock is lower. It should be remembered, however, that a preferred stock is always less attractive, logically considered, than a common stock making the same showing. For example, a $6 preferred earning $5 per share is intrinsically less desirable than a common stock earning $5 per share (and with the same prior charges), since the latter is entitled to all the present and future equity, whereas the preferred stock is strictly limited in its claim upon the future.
    In comparing railroad common stocks (and preferred shares equivalent thereto), the point of departure is the percentage earned on the market price. This may be qualified, to an extent more or less important, by consideration of items 10 and 19. Items 12 and 18 will indicate at once whether the company is speculatively or conservatively capitalized, relatively speaking. A speculatively capitalized road will show a large ratio of net deductions to gross and (ordinarily) a small ratio of common stock at market value to gross. The converse will be true for a conservatively capitalized road.
    Limitation upon Comparison of Speculatively and Conservatively Capitalized Companies in the Same Field. The analyst must beware of trying to draw conclusions as to the relative attractiveness of two railroad common stocks when one is speculatively and the other is conservatively capitalized. Two such issues will respond quite differently to changes for the better or the worse, so that an advantage possessed by one of them under current conditions may readily be lost if conditions should change.
    Example:
The example shown on p. 681 illustrates in a twofold fashion the fallacy of comparing a conservatively capitalized with a speculatively capitalized common stock. In 1922 the earnings of Union Pacific common were nearly four times as high in relation to market price as were those of Rock Island common. A conclusion that Union Pacific was “cheaper,” based on these figures, would have been fallacious, because the relative capitalization structures were so different as to make the two companies noncomparable. This fact is shown graphically by the much larger expansion of the earnings and the market price of Rock Island common that accompanied the moderate rise in gross business during the five years following.
    The situation in 1927 was substantially the opposite. At that time Rock Island common was earning proportionately more than Union Pacific common. But it would have been equally fallacious to conclude that Rock