Rule of Maximim Valuation for Senior Issues **Help**

Hello all. I am reading Security Analysis and I am having some trouble understanding the "rule" mentioned in my the title of this thread. For some of you who may find this stuff easy, please be easy on me... i am not a finance major. :p

Okay, so the rule states. You recapitalize a company that had (P)referred stock and (C)ommon stock with "hypothetical new (C')ommon stock " eliminating old Common issue giving Preferred issue all of the valuation. Basically the value of (C') can not be less than the value of (P). That seems pretty obvious to me. Graham gives example in his book:

(P) x 80 K Sh @ 118 = 9.44 mil
(C) x 200 K Sh @ 57 = 11.4 mil
Total Valuation = 20.84 mil

So if you recapitalize with new (C'), the old common is eliminated. (C') - 260.5 [20.84mil/80k]

In this case it seems obvious the rule is upheld. So my question is, why is it said preferred is priced too high at 118? :\ i don't understand how the above analysis proves the preferred is overvalued at 118.

Sorry for long post...

 
Kenny_Powers_CFA:
Because in the recapitalization the P receives par. Same reason bonds rarely trade above call price. If you pay 118 for preferred freely callable at par, you could get recapped at 100 tomorrow.
I still don't understand.

The "preferred stock was given stated Par value of 25$ and all the attributes of $100 par stock." It went up from 35 to 118. Graham's maximum value rules tries to tell us whether or not 118 is too high of a price for preferred issue. The preferred stock is not callable.

After recap, you can see that the new common stock is 256. Can you tell me how does this number relate to our original Preferred stock and how does it tell us that people who bought at 118 bought too high?

And:-

 

I think you may be over-complicating the point. I revisited my copy of Securities Analysis (6th Ed) and the point is that the company's preferred was being quoted at 118 because people expected to receive accrued dividends even though the fundamentals of the company didn't support the new implied enterprise value (C+P).

There have been many great comebacks throughout history. Jesus was dead but then came back as an all-powerful God-Zombie.
 
Best Response

I think you may be over-complicating the point. I revisited my copy of Securities Analysis (6th Ed) and the point is that the company's preferred was being quoted at 118 because people expected to receive accrued dividends even though the fundamentals of the company didn't support the new implied enterprise value (C+P).

There have been many great comebacks throughout history. Jesus was dead but then came back as an all-powerful God-Zombie.
 

Yeah i understood that part. The price shot up a lot because of speculation on dividends.

I was just trying to understand the point that was being made in regards to recapitalizing the company with New Theoretical Common stock. I still don't understand it. lol

What's the use behind that particular calculation and how does it prove that quotes price is too high?

Thanks a ton man! Appreciate your help.

 

If you had a similar company with no preferred (only common), the valuation of $20.8mm is too high given the fundamentals of the company. The valuation has only risen to that level because of expectations that the preferreds will receive dividends, not because of underlying business performance.

His point is that, if you had a company with only 80k shares of common worth the $20.8mm, the shares would trade at $260 on earnings of $6-clearly too high a valuation. He's not suggesting an actual recapitalization transaction take place.

There have been many great comebacks throughout history. Jesus was dead but then came back as an all-powerful God-Zombie.
 

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