3.3 VALUATION
3.3.1 Fundamental models for corporate bond spreads
A popular approach to estimate the credit risk of an issuer is the use of z-scores. In this context, Altman’s five components framework has attracted particular interest. On the company level, it is based on the five metrics depicted in Table 3.1.
Replacing the company-specific metrics by macroeconomic factors yields a fundamental model for the credit market. Because of the required minimum history and data reliability we will focus on the US market. Data for this procedure is taken from the flow of funds statistics and the national accounts of the United States.
The ratio of working capital to total assets measures the net liquid assets of a firm relative to the sum of financial and tangible assets. We isolated net liquid assets for the US nonfinancial corporate sector from the flow of funds statistics by subtracting mortgages, consumer credit, trade receivables and miscellaneous assets from total assets and subsequently adding invento- ries, trade and tax receivables. Figure 3.18 shows the working capital ratio over time. The large fall in 1974 is due to a significant decline in the value of trade payables. Usually, the ratio of working capital to total assets falls in a recession. But there also seems to be a secular downtrend in this ratio.
A common measure for profitability is the ratio of retained earnings to total assets. We defined retained earnings as undistributed profits, that is, after-tax profits minus dividend payments. Like the working capital ratio, the profitability measure is on a downtrend in the longer term. During reces- sions the profitability of the companies usually declines. It is worth noting that the latest recession in 2001 marks an exception with respect to the ratio of internal funds to total assets. Whereas the profitability declined like in any other recession before, the cash flows of the companies on average improved in this period due to rigorous cost cutting in the corporate sector.
Table 3.1 Factors of the Altman z-score model
Metric Interpretation
Working capital to total assets Net liquid assets relative to the firm’s assets
Retained earnings to total assets Profitability relative to size Earnings before tax and interest to Profitability relative to the
total assets firm’s assets
Market value of equity to total debt Inverse of leverage
Sales to total assets Sales generating capacity of a given asset base
Source:Altman [1968]
A second metric for profitability is the ratio of earnings before tax, inter- est depreciation and amortization (EBITDA) to total assets. Using data from the national accounts of the United States we define earnings before tax and interest as pre-tax profits with inventory valuation and capital consump- tion adjustment plus net interest. This metric follows a similar path as the ratio of retained earnings to total assets, although on a higher level and with a higher volatility (see Figure 3.19).
Measuring the extent to which a firm’s value can decline before its book value becomes negative and a firm becomes insolvent, the ratio of market value of equity to total debt represents the inverse of leverage. We have defined the value of equity as the market value of outstanding equities, total debt is defined as total credit market instruments. Figure 3.20 illustrates that the tremendous equity bubble of the late 1990s has collapsed, but nevertheless the equity-to-debt ratio stays above the level reached in the 1970s and 1980s. Because of its higher volatility, the ratio is largely driven by the equity performance. As a result the equity-to-debt ratio usually rises at the end of a recession because equity markets already anticipate stronger economic growth while many companies still delever- age their balance sheets. Here again, the 2001 recession makes an exception.
About one-and-a-half years after the end of the recession in November 2001 equity markets finally marked their lows.
Figure 3.18 Ratio of working capital to total assets for the US nonfinancial corporate sector
Source: Federal Reserve 17
20 23 26 29
(%)
32 35
52 54 56 58 60 62 64 66 68 70 72 74 76 78 80 82 84 86 889092949698 00 02 Working capital to total assets
Figure 3.19 Undistributed profits, earnings before tax and interest and internal funds versus total assets for the US
nonfinancial corporate sector
Source: Federal Reserve –1
0 1 2 3 4 5 6 7
(%) of total assets
8 9
52 54 56 58 60 62 64 66 68 70 72 74 76 78 80 82 84 86 889092949698 00 02 Undistributed profits Internal funds Earnings before tax and interest
Figure 3.20 Market value of equity outstanding to total credit market instruments of the US nonfinancial corporate sector
Source: Federal Reserve 0
50 100 150
(%) 200
250 300 350 400
52 55 58 61 64 67 70 73 76 79 82 85 88 91 94 97 00 03 Market value of equity to total debt
Finally, the ratio of sales to assets is an asset turnover ratio that measures the sales-generating capacity of a given asset base. Taking the nominal GDP of the nonfinancial corporate sector as a measure for sales, Figure 3.21 shows that the ratio has started to turn up at the beginning of 2001. This pattern is normally consistent with periods of recovery. However, it should be noted that this ratio is near its historical low.
To gauge the financial health of the corporate sector, we combine the five metrics of the Altman model applying the original weighting scheme.
Accordingly, the z-score is calculated as
Az-score below 1.8 signals that the company is in financial distress and the probability of default is high. The “grey” zone, indicating medium risk, ranges from 1.8 to 3. Scores above 3 are associated with “safe” companies.
Figure 3.22 illustrates that the z-score for the nonfinancial corporate sector has collapsed dramatically since 2000, resting well below the critical level of
⫹0.6 · equity total debt.
z ⫽ 1.2 · working capital⫹1.4 · retained earnings⫹3.3 · EBIT⫹sales total assets
Figure 3.21 Nominal GDP of the US nonfinancial corporate sector to total assets
Source: Bureau of Economic Analysis and Federal Reserve 27
29 31 33 35 37 39
(%)
41 43
52 54 56 58 60 62 64 66 68 70 72 74 76 78 80 82 84 86 889092949698 00 02 Sales to total assets
1.8 since the second quarter of 2002. For an individual firm this signals that the company is likely to fail within 2 years. On the macro level it indicates a high probability of rising default rates and widening credit spreads. Three points stand out from Figure 3.22:
■ based on macroeconomic data the z-score has never been in the safe zone;
■ the average score since 1952 is about 2;
■ in the 1970s and 1980s, the z-score was permanently in the distress zone implying that corporate America should have gone bankrupt, but clearly it survived.
This leads to the conclusion that the weighting scheme is no longer appro- priate to capture the vulnerability of the corporate sector. The relative importance of the individual factors changes over time. Therefore, it is nec- essary to adjust the weighting scheme on a regular basis, for example by using a regression methodology.
Figure 3.23 shows the results of two linear regression models based on Altman’s five indicators for the health of the corporate sector. In both models the factors are combined in a way so as to minimize the squared
Figure 3.22 Moody’s Baa corporate bond spread versus Altman’s z-score
Source: Moody’s and Union Investment 0
50 100 150 200 250 300 350 400
52 54 56 58 60 62 64 66 68 70 72 74 76 78 80 82 84 86 889092949698 00 02 1.0 1.2 1.4 1.6 1.8 2.0 2.2 2.4 2.6 2.8 3.0
Moody's Baa corporate spread Altman’s z-score (inverted rhs)
regression residuals (OLS regression). Regression model I fully relies on the five Altman factors. The second fundamental model includes as a sixth variable the oil price to capture the effect of oil price shocks on the economy and on credit spreads. Furthermore, some of the independent variables are lagged. Obviously, the fitted time series of the second model tracks the historical Baa corporate bond spread even better than the original model.