Any company may waste capital by doing business at a loss, or reduce it by paying out dividends without first making adequate provision for maintenance. Altho capital assets may depreciate, profits are nevertheless sufficient in many cases to enhance greatly the value of the business, calculated upon the basis of its earning power. In this event, actual de preciation of plant may occur, and yet the business may be under-capitalized. Over-capitalization itself is not an evil, nor can it be prevented by law any more than losses in business may be prevented by statute. Certainly no law can either prevent a business from losing money, or its assets from depreciating or from being destroyed by act of Providence.
Stock-watering, however, is both intentional and preventable, and without question it is often em ployed to deceive the unwary. On the other hand, stock-watering seems to be a financial necessity in pro motions. It is by no means easy to legislate out of existence the evils of this practice and at the same time retain its benefits.
3. Bases of capitalization.—Considerable confusion of thought arises because of the frequent failure to distinguish' capitalization from valuation. No one, for instance, ever thinks of capitalizing a business upon the cost of its reproduction, and yet that basis is mentioned by a number of leading authors. As a matter of fact, valuation is more important than capitalization. The total par value of the outstand ing securities is immaterial, but it is very important to know the actual value of the property. Any one or more of the following may serve as a basis of valua tion: 1. Actual cost 2. Cost of replacement 3. Earning power 4. Cost of reproduction.
Only three of these, however, are ever used as a basis of capitalization. The four bases of capitaliza tion are : 1. Actual cost 2. Cost of replacement 3. Earning power 4. Estimated willingness to buy, or gullibility, of the investing public.
If the promoters are on the water wagon, and the capitalization is "dry," the actual cost serves as the basis, with capitalization increasing no faster than capital as funds are required to expand the business. Adherence to this practice would cut out stock-water ing, but unfortunately it would also prevent the pro motion of many large corporations. As a rule, there fore, cost is a basis of capitalization only when the business is small or closely owned. But cost is not necessarily a conservative basis of recapitalizing an old business, the value of which may have no relation whatever to its original cost. Recapitalizing at cost
may still leave the stock highly watered if the assets have deteriorated.
The cost of reproduction refers to the present cost of producing a property similar to the old property in specifications and condition. The cost of replace ment refers to the present expense of replacing the old property by a modern type of equivalent capacity. The cost of reproduction is not a basis of capitaliza tion, because no one thinks of reproducing an old property, but rather of replacing it. Capitalization is regulated to suit the investor, and the investor is in terested only in what the property will earn, or what it will cost to replace it.
Earning power is the usual basis of capitalization. The securities of a business are worth only what they will earn; in other words, the par value of the se curities is fixed at an amount upon which the esti mated or actual income of the concern will pay the market rate of interest. For instance, a certain com pany has $60,000 available for bond interest and is able to issue bonds which investors are willing to pur chase upon a six per cent yield. It may issue bonds to the extent of one million dollars. The earning power has determined the amount of the capitaliza tion. Another corporation, with the same amount available, but able to borrow on a five per cent basis, might issue $1,200,000 in bonds against the same earn ings. This process is called capitalizing the earnings.
It should be noted, however, that often the earn ings are only estimated, or imaginary. When a run ring business is capitalized, earnings may be the real basis. If it is a new business, however, earnings may be the excuse, but imagination is the real basis. The actual basis in such case may be the amount of stock which the promoters think the public can be induced to buy. This is practically always the case with min ing companies, and, as to common stock, it was the basis of capitalizing the majority of the so called in dustrial trusts. Most of the great industrial com bines of the past twenty years based their bond and preferred stock capitalization upon estimates of real earnings, but their common stock capitalized nothing more tangible than the anticipated economies of market control or large-scale production and distribu tion.