CHAPTER NINETEEN
The Analysis
of Credit Risk
Stephen H. Penman
The web page for this chapter
runs under the following headings:
What
this Chapter is Doing
Cash
Flow Analysis is Central to Debt Valuation
Forecasting
Free Cash Flow
Utilizing
Information in Equity Prices for Bankruptcy Prediction
Updated Coefficients for Bankruptcy Scoring Models
A
Review of Value-at Risk Metrics
Special
Purpose Entities
What this Chapter is Doing
Up to this point, the book
has been devoted to equity analysis – that is, the information analysis
pertinent to the valuation of equity shares. This chapter deals with
credit analysis – that is, the information analysis pertinent to the
valuation of the other major claim on a firm, debt.
The valuation of debt is, in
principle, much simpler than equity. The payoffs to debt – at least
plain vanilla debt – are typically indicated in the borrowing agreement
(in the form of interest and repayment of principle). Thus, forecasting
payoffs -- that is so important to equity analysis -- is not of primary
concern. Rather, the main issue is the discount rate at which those
payoffs are discounted. This discount rate is determined by the risk
of the debt, and that risk is based on the probability of default. So
credit analysis is directed to assessing this probability.
Cash Flow Analysis is Central
to Debt Valuation
Credit analysis differs from
equity analysis in another way. While equity analysis focuses on accrual
earnings (or more precisely, residual earnings or abnormal earnings
growth), credit analysis focuses on cash flows. While profitability
is certainly necessary for a good credit rating on debt, it is the ability
of the firm to meet debt obligations with cash flow that is the ultimate
test. Accordingly, the pro forma analysis in Chapter 19 is directed
to forecasting free cash flow. Chapter 10 on the analysis of the Cash
Flow Statement has much more prominence in credit analysis than it does
for equity analysis.
Forecasting Free Cash Flow
While the target of pro forma
analysis for credit analysis (free cash flow) is quite different from
that for equity analysis (residual operating income or abnormal operating
income growth), the preparation of the pro formas (in this Chapter)
involves only a slight extension to those for equities (in Chapter 15).
This is because
Free
cash flow = Operating income – Change in NOA
Thus, once operating income
and NOA are forecasted, the free cash flow involves just one further
calculation. The amount available for debt service is just the amount
of free cash flow after paying the net dividend:
Cash available for debt
service = Free cash flow – net dividend.
F = C – I – d
A comparison of this number
with the debt service requirement indicates a default/non-default condition.
This calculation of free cash
free cash flow and cash available for debt service emphasizes the point
that a sound credit analysis must be preceded by an equity analysis:
While the emphasis of credit analysis is on cash, sound profitability
is the source of the cash generation.
Utilizing Information in
Equity Prices for Bankruptcy Prediction
Chapter 19 shows how default
and bankruptcy are predicted using financial statement measures. As
financial statements typically do not contain all the information the
bears on the prediction, default prediction models often add other non-accounting
information.
One scheme adds information
in equity prices: If default is likely, the firm’s stock price should
reflect it. Using market leverage (Debt/Market Value of Equity) as a
predictor, for example, adds information (in the market price) that
may not be indicated by book leverage (Debt/Book Value of Equity) because
a firm’s stock price decreases as it becomes more distressed.
Another scheme incorporates
estimated stock return volatility, as indicated by an option pricing
model (such as the Black-Scholes-Merton model): A firm with higher volatility
– and thus higher down-side risk – is more likely to default. The
following paper compares the predictive ability of methods using options
prices to those described in Chapter 19 (the Z-scoring and the Ohlson
logit probabilities), and finds that options prices contain more information
about the likelihood of bankruptcy than the predictions based solely
on financial statement information:
Hillegeist, S., E. Keating., D. Cram., and K. Lundstedt,
“Assessing the Probability of
Bankruptcy,” Review of Accounting Studies 9 (March 2004), pp.
5-34.
For further examination of
the ability of option prices to predict default and value bonds, see
Kealhofer, S.,
“Quantifying Credit Risk I: Default Prediction,” Financial Analysts
Journal (Jan/Feb 2003), pp 30-44.
and
Kealhofer, S., “Quantifying
Credit Risk II: Debt Valuation,” Financial Analysts
Journal (May/June 2003), pp 78-92.
Using prices for predicting
default works OK if those prices efficiently summarize information about
default. However, as with equity analysis, one runs the danger of including
inefficient prices in the analysis. In a bubble, for example, “high”
prices might be seen as indicator of low probability of default; however,
it is often the case that firms with bubble prices are those that go
bankrupt – as was the case in the collapse of internet firms when
the internet bubble of the late 1990s burst.
Updated Coefficients for
Bankruptcy Scoring Models
The coefficients reported in
the text for Z-scoring and logit probability scoring models are from
the original papers where the models were first proposed. The following
papers have more recent estimates:
Begley, J., J. Ming and S.
Watts, “Bankruptcy Classification Errors in the 1980’s: An Empirical
Analysis of Altman’s and Ohlson’s Models,” Review of Accounting
Studies 1 (1996), pp. 267-284.
Hillegeist, S., E. Keating.,
D. Cram., and K. Lundstedt, “Assessing the Probability of
Bankruptcy,” Review of Accounting Studies 9 (March 2004), pp.
5-34.
A Review of Value-at Risk Metrics
Value-at-risk metrics have
a long history. Go to the following for a history lesson:
http://econwpa.wustl.edu/eps/mhet/papers/0207/0207001.pdf
http://www.riskglossary.com/link/var_metric.htm
Special Purpose Entities
Special Purpose Entities (otherwise
known as off-balance sheet vehicles or variable interest entities) sometimes
imbed obligations that are not on a firm’s balance sheet. The Enron
SPEs were a classic reminder. For coverage of the accounting for SPEs,
see
Hartgraves, A.
and G. Benston, “The Evolving Accounting Standards for Special
Purpose Entities,” Accounting Horizons 16 (September 2002):
pp. 245-258.