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CHAPTER VII

THE BASIS OF CAPITALIZATION

O MUCH has been said of late years with ref

erence to the evils of over-capitalization and of

fraudulent practices in connection with stock watering, that it may be worth while to consider briefly the actual and the proper basis of capitalization of industries. It is ordinarily assumed in discussion by those who are opposed to what is generally called "stock watering," that stock ought to be issued for cash or for what is called the "actual cash value" of the property taken. It is generally assumed that the actual cash value will represent fairly well the cost of reproduction of the properties in present condition together with needed running capital in the form of cash on hand. Such an issuance of stock in an ordinary manufacturing business, under conditions of fair competition, will give dividends in the long run probably not materially different from, but perhaps somewhat higher than, the usual rate of interest in the community.

It seems to have been the purpose of the corporation law of Massachusetts, and of some other states and countries, to secure capitalization on this basis. The law passed by Congress for Puerto Rico after its annexation, took this position, and shows how conservative Congress tried to make its action on the subject. In Massachusetts, not merely must the directors or organ

izers of a corporation, part of whose stock is issued against property, make oath that the property has been received at its actual cash value, and that the stock is issued at this rate at par, but the Commissioner of Corporations of the state must also certify that he is satisfied that this is the case. Let us note just what this means. This is the capitalization of the value of the plant and running capital, not necessarily the capitalization of the value of the business as a going concern.

On the other hand, most business men are of the opinion that the value of any property depends upon its earning capacity, its value as "a going concern,' and that it is wise and just to determine the amount of the stock of a corporation upon that basis. In the case of corporations, such as those mentioned in the paragraph above, the probability is that the reproduction value of the establishments would correspond closely with the capitalization of their earning capacity at current interest rates. On the other hand, it must be remembered that much higher rates of profit can often be made, either (a) in times of more than usual business prosperity, or (b) under exceptionally skilful management, or (c) with the possession of considerable monopolistic power, from whatever source derived, whether the possession of patents, or of exceptional good-will, or of a very large capital. Mr. Bryan's early dictum that "only in the case of monopoly can you secure dividends upon stock that does not represent money invested" is not always strictly accurate; but it is so generally true that it ought carefully to be noted. The times of prosperity when this can be done without monopoly may be fleeting. The exceptional skill or

the monopolistic power are likely to endure for a longer season. Under those circumstances, with any of these advantages, the corporation might readily pay dividends of the usual rate of interest on a capitalization twice or three times the reproduction cash value of the plants.

Attention is frequently called to the case of a newspaper with a tangible property of, say, $100,000. Such a newspaper, ably edited, with a strong constituency of subscribers and a large advertising patronage, might readily pay good dividends on $1,000,000 or more. Why should the capitalization not be placed at $1,000,000, regardless of what the plant might cost? The earning capacity may be due largely to the skill of the editor, or to the fact of connection with some political party, or to the peculiar business skill of its advertising manager, or to the good-will gained through many years of skilful catering to the public taste. Why, it is asked, should not the capitalization be made upon its earning capacity rather than with reference to the cost of the plant?

A similar line of reasoning may be followed in the case of companies organized to exploit a patent to develop an exceptional opportunity as the ownership of an exclusive franchise or a rare waterpower. In these cases, of course, the element of monopoly enters directly. One rarely thinks of the talent of a great editor or of an exceptionally trained man in any field as a monopoly. Yet it may have many of the same business elements.

Most business men, as has been intimated, prefer capitalization on the basis of earning capacity. In the first place, if the dividends declared seem to be at about

the normal rate of interest, it conceals the actual state of the business from all persons not so situated that they either know the details of the business of this special establishment, or know that kind of business so well that they may readily judge the profits from external signs. This concealment of large profits lessens the temptation to rivals to enter the business, and lessens also the danger of popular disapproval, which is often expressed against those who make large profits upon capital invested, even though such profits may have been made more by the special individual skill of the manager than by the advantage that comes from the possession of capital. A prominent stockholder in a large gas company expressed the fear that it might be necessary soon to lower the price of his gas. The profits were becoming too large to please the public, and it seemed difficult to find an excuse for issuing more stock, though such excuses in the past had been found and for a time had served to conceal the rapidly increasing profits. A gas company, it should be remembered, too, is a public service corporation based upon a municipal franchise that is probably monopolistic in terms.

Again, a large capitalization is more advantageous, provided the stockholders wish to sell. If in any line of securities, for example, the stock of corporations that regularly pay dividends at 6 per cent. stands at par, those of similar nature and class of which the dividends are regularly 3 per cent. will usually stand at more than 50. People seem to like to deal in large figures, and there is also a greater element of speculation present perhaps in the latter case, though either motive is is

With the specu

probably largely an unconscious one. lative turn of mind goes the desire to get something for nothing, or the bargain counter attraction of cheap buying. A $100 stock listed at $50, seems at least to cheap and a bargain. But, whatever the reasons, because the stocks will sell for more usually, a large capitalization is often desired, even by conservative business men.

Still more is this the case if the business is speculative in its nature. Doubtless the stocks of many industries which have been largely overcapitalized are more pleasing to speculators on that account. They may not pay dividends; it cannot be expected that they will pay dividends in the near future; but on account of the instability of the business, their fluctuations up and down are more readily affected by rumors or by other slight influences on the stock market-and speculation flourishes on fluctuations.

It is claimed by many that the public is little affected by stock watering, and has little interest in the basis of capitalization. If the capitalization is high, the value of the stock will be correspondingly low, and vice versa. Business men will invest their money, it is thought, on the basis of actual values, as shown by earning capacity, regardless of the par value of the stocks, and neither prices nor investors are materially affected, whatever the basis of capitalization. After a business has been long established and its methods of management are well known, this contention is largely true. On the other hand, when new corporations are organized, and only those who are closely connected with the management know on what terms properties are purchased