Credit Ratings Are Still Important In Determining Stock Valuation

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Credit Ratings Are Still Important In Determining Stock Valuation

October 4th, 2010 hackel

During the height of the credit crises a short two years ago, the hint of a credit downgrade was sure to result in an outsized drop in the underlying stock. On the other hand, a confirmation of a rating pushed the impacted stock higher. Now, due to the considerable balance sheet re-liquefaction and built-up capital, the fear of a credit rating is not near as worrisome.

In reality, the effect of a change in credit worthiness can still be expected to have a considerable repercussion on valuation. And, with economic growth tepid, consumer confidence shaky, and public companies absorbing large amounts of capital thru stock buybacks and higher dividends, credit analysis is still particularly important.

Inasmuch as a credit shift signals increased probability of an alteration in free cash flows, whether it be their size, stability, or growth, the resulting income to the investor is impacted, hence ,so should the market valuations of the underlying financial securities.

Then what should be the role of the credit rating on stock valuation?

Realistically, credit ratings impact firms differently, with those enterprises which rely on a continuing and growing need for credit more sensitive to the analysis of the nationally recognized statistical rating organizations (NSRO). But even for firms which only sparingly tap the credit market, their cost for standby lines of credit, bankers acceptances, or other facilities, will be higher than that for lower rated credits. In addition, covenants tied to debt will be more restrictive for lower rated credits, forcing up their cost of capital. Low rated firms may be also forced to consider capital from non-traditional lenders, including private equity and hedge funds.

For companies that are rated by the NSROs, the analyst should examine when the rating was assigned. Have conditions changed? It is also the responsibility of the analyst to determine if the entity under consideration had its securities rated as a one-time evaluation (called a point-in-time rating) or is under a regular review rating service.

Even for entities undergoing regular reviews, ratings may be dated compared with real-time information being reflected in the marketplace. Here, credit spreads can often be insightful.

Credit ratings impact cost of capital and stock valuation in a myriad of ways. Higher ratings not just allow for lower borrowing costs but can be a magnet for additional business and better terms from suppliers.

As such, enterprises attempt to maintain their leverage and fixed charge ratios at a desired (target) level, or to improve or take actions to improve their averages to that level. Firms also compare their financial ratios to others in their industry, relative to their respective credit ratings.

Some entities will be comfortable taking on debt, even though it may mean sacrificing a credit rating, if it means improving return on invested capital (ROIC). If investors believe a project or acquisition will be value enhancing, bonds will normally be placed at the expected interest rate, and cost of capital remain stable, even if the rating is slightly lowered. If the projected capitalization is inconsistent with its current rating, a rating change will most likely take place, and so the Board of Directors must decide if such a project is worth the incremental cash flows over the longer run. If the project or acquisition will bring in long-term value which will restore the capitalization, then perhaps the rating agencies would overlook the temporary blip in the financial structure.

Credit ratings are also important in that the rating agencies may have confidential access to information shared by the enterprise which is not reflected in current risk assessment. In the cost of capital model (encompassing 60+ metrics) we use at CT Capital, the lower the credit rating, the greater the penalty assessment, since the credit rating has a significant effect on the cost of doing business. For example, many companies selling outside the US rely on the credit rating when basing their purchase decisions. Other companies have their cost of debt significantly raised or lowered due to a change in their rating, while financial and regulated companies might be required to commit more capital to subsidiaries if their ratings are lowered. Also, ratings affect the entity’s supplier and customer decisions, regarding their willingness to supply or order.

If a customer’s ratings are lowered, their business could be negatively affected. For the financial aspect of the business, adverse down-grades could require additional collateral to be placed with creditors and counterparties. The effect of a change in the credit rating in CT Capital’s cost of capital model will thus vary from insignificant to very significant.

Additionally, many pension funds are prohibited from owning debt below a certain grade, while other funds may own no greater than a small allocation to lower grades. Thus, the higher the grade, the greater the potential demand for an entity’s fixed income instruments, and commensurate lower cost of debt.

Standard and Poor’s has published key financial ratios with their commensurate ratings (shown as Table 1). As depicted in the table, the greater the leverage and lower the fixed charge coverage, the lower the credit rating, on average. In actuality, a credit rating takes into account many factors, some being non-financial, such as the willingness of an entity to reduce its leverage.

The credit model used at CT Capital (as well as credit rating agencies) are far more comprehensive than this table, however these key ratios provide a reasonable guide from which additional credit work can take place. For instance, at CT Capital, EBITDA is not part of the credit worksheet as we focus on free cash flow, including serious adjustments to published financial statements (See ‘Security Valuation and Risk Analysis’ for extensive discussion of this and other topics). Also, S&P defines free operating cash flow as cash flow from operating activities minus capital spending. At CT Capital, we also make various adjustments to operating cash flows and then add back a percentage of discretionary spending, known as corporate “fat.”

It is where a difference exists between a NSRO rating and CT Capital’s credit worksheet when a rating change is most likely.

Using metrics from S&P Key Financial Ratios (Table 1), we look at Intel (INTC) inTable 2, which S&P assigns a rating of A+; the table reveals Intel is really closer to AAA credit. From a stock valuation viewpoint, Intel should be accorded a higher multiple than the median A+ credit, other factors held constant. Tables 2,3, and 4 are data from financial statements gathered by Research Insight, a division of S&P.

Table 1
Key Financial Ratios Standard and Poor’s

Standard and Poors Debt Medians

Table 2
Intel (INTC) Implied Credit Based On S&P Key Metrics

Table 3 below shows Alcoa (AA) is rated above what its financial ratios imply based on S&P key ratio guidelines. Alcoa is actually rated BBB- by S&P, versus an implied rating of B.

CT Capital’s studies have shown there is a size bias with ratings firms as they tend to assign a higher rating to firms having higher market valuations (see Security Valuation and Risk Analysis). Using the CT Capital credit model, Alcoa is also shown to be rated by S&P above its implied credit score, hence one should expect a credit downgrade for Alcoa unless its financial performance improves from 2009. Even if its credit is not lowered by an NSRO, its credit strongly suggests its free cash flows to be more uncertain than is generally perceived. From a stock valuation viewpoint, Alcoa should be accorded a lower multiple than similar credits. As seen in the table, Alcoa’s credit has been deteriorating based on the S&P scorecard.

Table 3
Alcoa (AA) Implied Credit Based On S&P Key Metrics

A credit rating is also important to determining cost of capital (and valuation) for those firms which are not currently rated by an NSRO, like RealD (RLD), which was founded in 2003 and went public in 2010. RealD ($850MM equity market value) has just $ 38MM in debt and lease obligations, and is not rated by S&P, has an implied rating of BB (Table 4) based on key financial ratios of table 1. Firms like RealD, with a higher market capitalization than its free cash flow would infer, typically become active in the equity and credit markets, hence the need to imply a rating.

Table 4
RealD Inc. (RLD) Implied Credit Based On S&P Key Metrics

So, while credit changes are not making the same splashy headlines they were a couple of years ago, they soon might very well be will, for as we harshly learned, what goes around comes around—especially when it comes to credit.

Disclosure: No positions

Kenneth S. Hackel, CFA
President
CT Capital LLC

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If you are interested in learning more about cash flow, financial structure and valuation, order “Security Valuation and Risk Analysis” out this fall from McGraw-Hill.

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