Six Sigma and Beyond: Design for Six Sigma, Volume VI

We first encounter rating systems on our grade school report cards ” and spend the rest of our lives complaining about their inadequacies. Financial rating systems, too, have their limitations, but they can be an effective means of getting a quick measure of financial strength.

Financial rating companies have been around for most of this century. Even now, in this age of rigid accounting standards and computer assisted analyses, business-people continue to rely heavily on rating services rather than doing the rating themselves . Apparently, the virtues of the rating companies ” thoroughness, consistency, and conservatism ” outweigh their draw-backs of old information, obscure criteria, and cost in the minds of many users.

Rating services are best employed where the user is dealing with a large number of companies, and the investment or credit risk the user is taking with any one of them is small. But if the risks are concentrated or a lot of money is at stake with particular companies, the user should learn to make the analysis personally or at least be able to confirm the judgment of the rating companies. Research studies have shown that the rating firms are often slow to react when a company's financial strength is on a downslide.

BOND RATING COMPANIES

The generally wealthy institutions and investors who buy most bonds make extensive use of rating services; over 4000 issues are rated on a regular basis. Stripping it to its essentials, the analytical process is one of comparing:

1. Total debts against expected future profits, which are the primary source of interest and principal payments

2. Total debts against total assets, the liquidation of which is a secondary, albeit dire, source of repayment

Moody's et al.

Moody's and Standard and Poor's are the best known of the bond rating companies. Neither of these firms reveals exactly how they arrive at their ratings, but the following criteria figure prominently in their classifications.

1. Financial leverage; the lower the leverage, the better the rating.

2. Profitability or rather, the avoidance of losses.

3. Steadiness of profits, the importance of which has led many firms to attempt "managing" or smoothing out their year-to-year earnings.

4. Total revenues or extent of market share; being an industry leader makes you a stronger competitor or is it the other way around?

Both Moody's and Standard and Poor's use letter ratings beginning with triple A. Here are samples of the definitions they give their classifications.

Moody's

Aaa Bonds carry the smallest degree of investment risk and are generally referred to as "gilt edge." Interest payments are protected by a large or an exceptionally stable margin and principal is secure.

Caa Bonds are of poor standing. Such issues may be in default or there may be present elements of danger with respect to principal or interest.

Standard and Poor's

AAA is the highest rating and indicates an extremely strong capacity to pay principal and interest. Bonds rated BB, B, CCC, and CC are regarded, on balance, as predominantly speculative with respect to the issuer's capacity to pay interest and repay principal in accordance with the terms of the obligation.

As one can see, neither company gets very specific about the meaning of the ratings, and no attempt is made to predict the future of the subject firm. Rather, the ratings convey a "feeling" about it. That feeling represents the risk side of the investment equation:

Risk = Return

The return, on the other hand, is represented by a specific number ” the bond's yield. Now, if the bond's rating could also be expressed as a specific number ” the percentage probability of loss ” investment decisions would be greatly simplified.

The rating agencies maintain a rigid independence from the companies they analyze. Rigidity is necessary because of the millions of dollars of higher or lower interest costs that often ride on the change of a rating (that is, in subsequent bond issues, not the ones outstanding). Now and then you will see a company emit an outraged howl at being downgraded.

RATINGS ON COMMON STOCKS

In addition to rating bonds, these firms rate preferred stock and commercial paper on similar scales . As to common stocks, there are hundreds of companies that dispense investment advice. While a few confine themselves to issuing data, most have some subjective or objective method of selecting stocks for purchase or sale. None give full descriptions of the selection process, of course, because their advice, and the mystique that surrounds it, are all that they have to sell.

Among the major services there are two that have established rating systems for use in selection of common stocks: Standard and Poor's and The Value Line Investment Survey. Standard and Poor's publishes a monthly stock guide that is crammed with financial data on about 5000 common and preferred stocks. Most of the stock issues are rated on an eight-level scale running from A+ (highest) to D (in reorganization).

The S&P Rating Method

The rating formula is based on a computerized scoring system that traces the trends of earnings and dividends over the previous ten years . The basic scores are then adjusted for growth, stability, and cycles; final scores are measured against a matrix of a large sample of stocks. The Standard and Poor's (S&P) rating serves well enough as a measure of a company's past performance; but as it ignores the condition of the balance sheet and future earnings estimates, it is only a starter in an investment analysis. Considering the price of the analyses, however, about ten cents a gross, there hardly seems to be grounds for complaint.

The Value Line Method

The Value Line Investment Survey tracks over 1700 companies on a regular basis. Using unpublished equations, it rates each company for "safety" and investment "timeliness." Both factors are ranked on a scale of 1 (highest) to 5 ( lowest ), the rankings being relative to all 1700 stocks, not to some absolute standard. The Value Line safety ranking is based on such factors as leverage, fixed charge coverage (the number of times over that profits could pay the annual interest expense), liquidity, and the riskiness of that type of business. The timeliness factor is a comparison of a stock's price trend against its expected earnings. A company may have a terrific near- term profit outlook, but if the market price of its stock is hovering somewhere in the stratosphere, it may not be a " timely " buy.

Good Ole Ben Graham

Among the published formulas for investing in stocks, one of the most famous and enduring is based on the "intrinsic value" theory of the late Benjamin Graham. Professor Graham, a pioneer in "fundamental" analysis, did most of his research in pre-computer days when computations were made on those clunky mechanical calculators and laboriously recorded by hand. Graham's notion was that stocks at any given time are likely to be undervalued or overvalued; that is, many investors are buying and selling shares for reasons other than their fundamental value. The smart investor will appraise that value (relative to the price) and snap up the undervalued bargains. Among the criteria Graham proposed were the following:

1. For financial soundness, a ratio of total liabilities to current assets of no more than 60%

2. A ratio of equity to total debt of at least 1007; Mr Graham often said, "a company should not owe more than it is worth."

3. One buy signal: a price less than 2/3 of the "net-current-asset" value, defined as

   Current assets - (Total liabilities + Preferred stock)/Number of shares outstanding.

4. Another price criterion: the earnings to price ratio (the reciprocal of the P/E ratio) should be at least double the average Triple-A bond yield for industrials. So if the bonds were averaging 10%, the E/P ratio should be at least 207, which means a P/E ratio of 5 or less.

Special warning: Before you rush out and sell the farm to try one of these stock market systems, be aware that no system has ever had a consistent, long-term run of higher than average profits. Even Ben Graham's common-sense method suffers from the perverse nature of the market: No matter how adept you become at finding "undervalued" stocks, the only way you can make money on them is if the rest of the investors come to the same realization soon after you have bought some shares. Sometimes they never do, and you could be left sitting on top of an undiscovered gold mine until it is, well, too late.

COMMERCIAL CREDIT RATINGS

Dun & Bradstreet

Dun & Bradstreet is the granddaddy of commercial credit rating firms. While its main business is furnishing information about a company's finances and paying habits, it also assigns two ratings to those firms about which it has sufficient information. The first is a 15-level scale of a firm's "estimated financial strength" or equity. The highest classification is 5A for companies with a net worth of $50 million or more; midway down the list is BB, $200,000 to $299,999; the lowest rank is HH, covering an equity less than $5,000. D&B will only issue a rating when it can obtain an equity figure, usually from the subject company, and has no reason to think it is inaccurate.

The second rating is a "composite credit appraisal," which is derived by an unpublished formula, presumably taking into account a company's liquidity, leverage, and profitability, as well as paying habits and any adverse events such as tax liens. This appraisal has four grades:

Each credit appraisal is done in conjunction with the financial strength rating, so that the "1" in a rating of EE1 does not reflect the same standards as the "1" in 4A1. While there are smaller credit agencies that also issue ratings, D&B's system stands virtually alone. So extensively is it used by vendors granting trade credit that for thousands of firms a good D&B rating is all that is necessary to establish an open account.

Other Systems

Sometimes, a do-it-yourself approach is used in evaluation. That means the analyst uses multiple statistical tools to create a scoring system. Two major approaches are known for this endeavor.

The first type consists of systems that base their ratings on a statistical analysis. The methodology is to gather a bunch of financial statements, several years' worth, from companies that have gone bankrupt, and a bunch from otherwise similar companies that have remained afloat. Various ratios are then calculated in an effort to find those indicators that best distinguish the one group from the other.

Perhaps the best-known work in this field has been done by Professor Edward I. Altman of New York University, who in 1968 developed a statistical model for the prediction of corporate bankruptcy. Altman's formula, known as the "Z score," combined five ratios selected by an advanced statistical method called discriminant analysis, which searches out the best combination of ratios rather than the single best ratio for predicting the future. The five ratios, shown in Table 15.3, are multiplied by conforming factors, and the products are added together to get the score.

The critical Z Score was 1.81, according to the study, which found that all of the firms in its group with a score that low had gone bankrupt. Moreover, the model correctly classified 959 of the total sample one year prior to bankruptcy. (A note for this analysis: This test did not hold its effectiveness for the long term as an increasing proportion of its predictions became false. In 1977, Professor Altman revised the Z score but again it has not caught on.)