17. is a written, signed, and sealed evidence of ownership in a corporation, and of a fractional claim to its free assets and surplus earn ings. The bondholder has a margin of safety as to his principal in the property contributed by the stock holders, or which has been put back into the business out of earnings. The bondholder's interest is pro tected in the surplus earnings remaining after fixed charges are deducted. The stockholder has no mar gin of safety unless there be a division of stock into classes. His property is itself the margin.
The par value of most railway and industrial stocks is $100. Reading, Pennsylvania, Lackawanna, Westinghouse Electric and United Gas Improvement are $50 par. In the mining business par varies from $100 down to $1.00, and even to one cent, no sum in multiplication and division being too ridiculous for some of the promoters who harass this industry. When stock is issued fully paid and non-assessable the owner is not liable personally for the debts of the corporation except in the case of bank stock and some times of trust company stock (as in New York since 1888).
In America preferred and common stocks are the only two divisions recognized, altho there are a num ber of companies which subdivide preferred stock into first and second. Apart from very rare cases pre ferred stocks are preferred as to dividends, the rate of which is designated. They may also be, and usually are, preferred as to assets. The cumulative feature is not a guarantee of dividends, as the follow ing tabulation of dividends overdue will show: Preferred stock may be callable at the option of the corporation and it may be convertible into com mon stock at the option of the holder. It may be participating; that is to say, having a right to share equally with the common stock in dividends above a designated and usually equal base rate.
Preferred stock originated in railway reorganiza tions in the process of scaling down bonds. The popularity of this form of security at the present time may be said to prove that the number of investors who desire protected investments and reasonably as sured yields is larger than can be accommodated within conservative bonding limits. Accordingly, a compro mise security standing between bonds and stocks is employed to answer this need without creating a fixed charge on revenues.
18. Safeguards for preferred safety devices have been invented to safeguard pre ferred stock. Two plans commonly employed are the restriction of dividends on the common stock and the provision that no obligations with claim prior to the preferred stock shall be placed on the property ex cept with the consent of two-thirds or three-fourths in interest of the holders. Other safeguards are the provision of a sinking fund to retire the preferred stock, and the stipulation that in case there is a de fault in dividends the preferred stock shall have vot ing power.
Too much confidence should not be placed in these safeguards. If a property is bonded to the safe limit, the hazards of the business cumulate upon the margin left for the stockholders. As for the restric
tion placed upon the issue of prior liens, the pre ferred stockholders will readily come to the borrowing of money when conditions present to them the option of doing so or of facing a reorganization. As for the provision that current assets must be maintained in an amount at least equal to the par value of the pre ferred stock, conformity to such a provision is mainly a matter of determining the kinds of items which are to be classified as current assets, and of the methods of making appraisals.
19. Tests of good preferred stock.—An investment in stocks is not so much the hazard of property as the hazard of management, business policies and general business conditions. The tests of a sound industrial preferred stock have been given by Mr. W. Martin Swift as follows: (1) That increases of capitalization, except for the pur pose of acquiring new plants which carry with them a pro portionate increase in the volume of business done, should arouse doubts as to the investment value of a preferred in dustrial ; and (2) That earnings available for preferred dividends, in order to render the issue high-grade, should be about double the dividend requirements; (3) That in the case of a company having a bonded debt, these earnings should be more than double—increasing some what in proportion to the relative size of the debt ; and (4) That working capital as disclosed by the balance sheets should show an increasing tendency, except in years of business depression; and (5) That these increases should not ordinarily be re garded as genuine unless they are reflected in the prices of the company's securities ; and (6) That bonded debts should not, in any event, exceed 50 per cent of the aggregate market value of the outstand ing securities ; and that where they exceed 35 per cent, earnings on the preferred stock should be exceptionally large.
20. Tests of good common stock.—The tests of a good common stock are, to a greater extent than for a preferred stock, the tests of administration. They may be divided into three categories: the appropriate ness of the property and physical processes employed for the purposes of the business, the financial condi tions as revealed by the balance sheet and income ac count, and the mercantile policies involved in selling, credit giving, collections, etc. A somewhat common test is the dividend record. Reference will be made to this in the last chapter of the Text. The test is dangerous for short periods, since one of the surest ways to ruin a property is to pay dividends out of capital or strip a business of its working capital. It is at its best for intermediate lengths of time, say from eight to twelve years, for in such a period the power of the business to weather a severe reaction in trade will be tested. It is unfair as a relative test for very long periods, for few corporations have had a very long life in "changing America." The real test is not the dividend record, but surplus earnings over fixed charges, and the soundness of the judg ment displayed in employing them.