Security Analysis by Benjamin Graham and David Dodd was first published in 1934. It is a fundamental book for serious students of value investing.
In this chapter, Mr. Graham and Mr. Dodd lay out an additional test for investment bond selection.As discussed in prior chapters, the assets of the company are not a sure way to provide bond safety, it is the value of business above the debt that provide assurance for safety. In that regard, earning coverage test (average earnings over fixed interest charges) works, however relying on just one test could be dangerous because earning record fluctuates. Thus, having an additional test is important.
The authors recommend stock-value test, wherein the market value of the company should be compared with the debt. A higher value of equity lying behind the debt adds to the safety of the bond. This test's importance increases for companies in industries that are changing and are less regulated. However, there could be cases where both earning coverage and stock-value tests could provide contradictory signals. The authors recommend against assuming the depressed market value of the stock when making bond investments.
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