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Tracking Default Risk of S'pore Firms
Source: Business Times Singapore
Date: January 18, 2005
Author: N/A
With corporate shocks like Informatics and China Aviation Oil fresh in investors' minds, and considering the volatility of today's market, the need for a rating model that can help stakeholders rate the performance of both listed and private companies is apparent.
Such a tool would help investors monitor a company's performance and track the probability of default. The challenge is to select the most appropriate model that is able to incorporate local market sentiment in its assessment.
One popular method is the use of structural models that examine a company's balance sheet to evaluate its financial strength. This approach assumes that corporate debt can be seen as an option on a company's assets. This provides the basis for comparing the value of the company's assets to that of its liabilities. Should a company come to a point when debts outweigh assets, it will be considered to be in default.
The Kealhofer, McQuown and Vasicek (KMV) model is among the best known for using the approach. It was recently acquired by Moody's and renamed Moody's KMV. This model estimates the expected default frequency (EDF), or a company's probability of default by determining:
The market value of the assets (through market value of equity), Asset volatility (risks that reside in the asset value through historical price volatility of the company) and Debt level of the company (leverage ratio of debt versus equity, structure of the liabilities, the average interest paid on the debts and the risk-free rate).
The default point is determined as the point where the asset value drops below the value of current liabilities. DP Information Group adapted the rating model to the Singapore context, translating the different default probabilities to a rating ranging from DP 1 (low credit risk) to DP 8 (high credit risk).
In comparison to traditional rating methods which concentrate on balance sheet numbers, DP's Corporate Rating model, in addition to looking at the liabilities structure and debt ratios, also takes into consideration the volatility, as well as the market value of a company's assets (which are more reflective of a company's worth than accounting-based book value), in assessing a company's financial standing.
A rating of DP 1 to DP 4 is comparable to investment-grade rated securities, while DP 5 to DP 6 is comparable to high-yield rated securities and DP 7 to DP 8 equivalent to high-risk rated securities.
Applying DP Corporate Rating to Singapore's top revenue generators in the S1000 list of companies (excluding companies in the finance and property sectors), we note that close to 55 per cent have attained investment-grade ratings of between DP 1 and DP 4, highlighting their financial strength. (see Table 2).
By industry, manufacturing and wholesale saw the biggest proportion of investment-grade companies, at 31.5 per cent and 31.3 per cent respectively. The communication, transport and storage sector was next with 15.5 per cent.
Comparing the two ranking periods, 148 companies that were previously rated as high yield (DP 5 to DP 6) have seen their DP rating improved to investment-grade (DP 1 to DP 4) while 38 of those that were previously rated as high risk (DP 7 to DP 8) saw their default probability improved to below 3 per cent, reflecting improving market sentiment and a stronger stock market performance in 2004.
As improvement in market assets is a key factor in the rating model, the economy's 8.1 per cent economic growth and the stock market's 16.7 per cent gain in market capitalisation in 2004 positively impacted the rating for all these companies. More encouragingly, the number of companies rated DP 1 jumped from 28 in the previous ranking to 165 in the current ranking (up 489 per cent). The number of investment-grade companies (those rated DP 1 to DP 4) nearly doubled from 250 companies to 496 companies (see Table 1).
DP 1 companies generally have strong financial fundamentals with a high incentive and capability to repay obligations. They have a default probability of less than 0.1 per cent within a year of the rating.
While the manufacturing sector had the highest number of DP 1 companies, the sector that saw the greatest increase in DP 1 companies was the communications, transport and storage sector. It saw a jump from two companies to 42. The manufacturing and wholesale sectors also saw their DP 1 representation increase by 47 companies and 26 companies respectively.
The improvement in the rating of this year's S1000 companies is largely a result of the improved economy, leading to higher stock prices (market value) and lower asset volatility - two key measurements in the tabulation of DP Corporate Rating.
Within the communications, transport and storage sector, improving air cargo demand and sea trade helped contribute to growth, while robust global demand for semiconductors and strong growth in the petrochemical and biomedical sector fuelled growth in the manufacturing sector.
The wholesale sector was boosted by improved entrepot trade and strong demand for biomedical, petrochemical and electronics products from the US and Europe.
In terms of debt, recent corporate failures like Enron and Global Crossing have made companies more prudent in managing debt and more careful to avoid cash flow traps.
Article contributed by DP Information Group, ranking body of the Singapore 1000 & SME 500.
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