a literature review of concepts of credit ratings and corporate valuation

Vinod Gupta School of Management, IIT Kharagpur

AMRP Report:

A Literature Review of Concepts of Credit Ratings

and Corporate Valuation:

Find the Scope of developing a correlation model

This report is submitted in partial fulfillment of the requirements for the AMRP Evaluation

in the Third Semester at Vinod Gupta School of Management, IIT Kharagpur (2010-2012).

Under the Guidance of

Prof. Arun Kumar Misra

VGSoM, IIT Kharagpur

Submitted by

Harsh Vyas

10BM60030


Acknowledgement

I would like to express my gratitude to my faculty guide, Prof. Arun Kumar

Misra for helping me cover this much part of my Advanced Management Research

Project this far.

I would also like to thank my parents, friends, other colleagues and my

college faculty who have always been very cooperative whenever I have needed

them. In the end I would like to thank all those who have been associated with my

AMRP and this Project Report.

Harsh Vyas


TABLE OF CONTENTS

Abstract

Credit Ratings

Credit Score

Various types of Credit Ratings

Various Methodologies of Credit Rating

Literature Review on Credit Ratings

Rating Methods

Parameters

Issues on Ratings

Company Valuations

Methods of Corporate Valuations

How valuation is linked to rating

Rating Vs Valuation: A conclusion


Abstract

Credit Rating of a Bond or Security represents a third party view of the solvency or default

probability of the security in question, and in correspondence the corporate or government

entity which has issues those bonds. The world famous credit rating agencies are primarily

based out of United States of America. Of them Standards & Poor, Moody’s and Fitch are

the most relevant. All of them have their subsidiary in India as well. For example, Crisil is a

subsidiary of S&P in India. These credit ratings use a lot of acronyms like AAA, AA, A+, BBB

etc to denote the credit-worthiness of the bond issuer. In these days of Euro turmoil, even

the ratings of Sovereign government bonds have come under fire, like what happened with

the United States when its Sovereign Bonds/Gilts were de-rated to AA from the Platinum

AAA. The direct impact of any rating downgrade be it on a government or a corporate is a

direct increase in its cost of debt. A more secure rating means a lesser probability of

defaulting and thus the risk premium on interest rates becomes lesser than that on a more

risky investment. To ascertain this rating, Credit Rating Agencies use a verity of methods,

which include both quantitative as well as qualitative models and sometimes opinion based

models too. The usual parameters that are considered are: County Risk, Market Risk,

Industry position, Profitability and peer group comparison all of which can be clubbed as

Business Risk and then there is the inherent Financial Risk related to accounting

(mal)practices, Governance, Risk tolerance, financial policy, cash flow adequacy, capital

structure and liquidity/short term factors.

Corporate Valuation Techniques try to ascertain the present value of a corporation based on

its current economic parameters and future earning potential. They typically use parameters

like discounting of future cash flow, dividend discount models, Gordon growth model etc. to

find the value of what a corporation is worth right now in its sum total. A direct impact of

change in Credit Ratings is the change in its borrowing cost. Which in turn changes the

Weighted Average Cost of Capital (WACC). This in turn affects the corporate valuation

because any such valuation calculation is typically done keeping in mind actual cost of

capital and opportunity cost of assigning the capital into some other corporation.

This brings us to the crux of the matter. My aim through this advanced management

research project is to analyse the publically available data of a few large Indian/Foreign

Corporations and develop a chart where based on the Corporate Valuation Data and

Financial Statements we are able to predict Credit Ratings of a Corporate Bond and vice-

versa. This correlation model will help us identify underrated/overrated bonds and help us

assess fair valuation for the corporate.


Credit Rating

A credit rating evaluates the credit worthiness of an issuer of specific types of debt,

specifically, debt issued by a business enterprise such as a corporation or a government. It

is an evaluation made by a credit rating agency of the debt issuers likelihood

of default. Credit ratings are determined by credit ratings agencies. The credit rating

represents the credit rating agency's evaluation of qualitative and quantitative information for

a company or government; including non-public information obtained by the credit rating

agencies analysts. Credit ratings are not based on mathematical formulas. Instead, credit

rating agencies use their judgment and experience in determining what public and private

information should be considered in giving a rating to a particular company or government.

The credit rating is used by individuals and entities that purchase the bonds issued by

companies and governments to determine the likelihood that the government will pay its

bond obligations.

Credit ratings are often confused with credit scores. Credit scores are the output of

mathematical algorithms that assign numerical values to information in an individual's credit

report. The credit report contains information regarding the financial history and current

assets and liabilities of an individual. A bank or credit card company will use the credit score

to estimate the probability that the individual will pay back loan or will pay back charges on a

credit card. However, in recent years, credit scores have also been used to adjust insurance

premiums, determine employment eligibility, as a factor considered in obtaining security

clearances and establish the amount of a utility or leasing deposit.

A poor credit rating indicates a credit rating agency's opinion that the company or

government has a high risk of defaulting, based on the agency's analysis of the entity's

history and analysis of long term economic prospects. A poor credit score indicates that in

the past, other individuals with similar credit reports defaulted on loans at a high rate. The

credit score does not take into account future prospects or changed circumstances. For

example, if an individual received a credit score of 400 on Monday because he had a history

of defaults, and then won the lottery on Tuesday, his credit score would remain 400 on

Tuesday because his credit report does not take into account his improved future prospects.

Credit Score

A credit score is a numerical expression based on a statistical analysis of a person's credit

files, to represent the creditworthiness of that person. A credit score is primarily based

on credit report information typically sourced from credit bureaus.

Lenders, such as banks and credit card companies, use credit scores to evaluate the

potential risk posed by lending money to consumers and to mitigate losses due to bad debt.

Lenders use credit scores to determine who qualifies for a loan, at what interest rate, and

what credit limits. Lenders also use credit scores to determine which customers are likely to


bring in the most revenue. The use of credit or identity scoring prior to authorizing access or

granting credit is an implementation of a trusted system.

Credit scoring is not limited to banks. Other organizations, such as mobile phone

companies, insurance companies, landlords, and government departments employ the

same techniques. Credit scoring also has a lot of overlap with data mining, which uses many

similar techniques.

FICO is a publicly-traded corporation (under the ticker symbol FICO) that created the best-

known and most widely used credit score model in the United States.

Score interpretation

The first step to interpreting a score is to identify the source of the credit score and its use.

There are numerous scores based on various scoring models sold to lenders and other

users. The most common was created by Fair Isaac Co. and is called the FICO score. FICO

produces scoring models that are most commonly used, and which are installed at and

distributed by the three largest national credit repositories in the U.S (TransUnion, Equifax

and Experian) and the two national credit repositories in Canada (TransUnion Canada and

Equifax Canada). FICO controls the vast majority of the credit score market in the United

States and Canada although there are several other competing players that collectively

share a very small percentage of the market.

In the United States, FICO risk scores range from 300-850, with 723 being the median FICO

score of Americans in 2010. The performance definition of the FICO risk score (its stated

design objective) is to predict the likelihood that a consumer will go 90 days past due or

worse in the subsequent 24 months after the score has been calculated. The higher the

consumer's score, the less likely he or she will go 90 days past due in the subsequent 24

months after the score has been calculated. Because different lending uses (mortgage,

automobile, credit card) have different parameters, FICO algorithms are adjusted according

to the predictability of that use. For this reason, a person might have a higher credit score

for a revolving credit card debt when compared to a mortgage credit score taken at the

same point in time.

The interpretation of a credit score will vary by lender, industry, and the economy as a

whole. While 620 has historically been a divider between "prime" and "subprime", all

considerations about score revolve around the strength of the economy in general and

investors' appetites for risk in providing the funding for borrowers in particular when the

score is evaluated. In 2010, the Federal Housing Administration (FHA) tightened its

guidelines regarding credit scores to a small degree, but lenders who have to service and

sell the securities packaged for sale into the secondary market largely raised their minimum

score to 640 in the absence of strong compensating factors in the borrower's loan profile. In

another housing example, Fannie Mae and Freddie Mac began charging extra for loans over

75% of the value that have scores below 740. Furthermore, private mortgage insurance

companies will not even provide mortgage insurance for borrowers with scores below 660.

Therefore, "prime" is a product of the lender's appetite for the risk profile of the borrower at


the time that the borrower is asking for the loan.

The Credit Information Bureau (India) Limited (CIBIL) was incorporated in 2000 by

the Government of India and the Reserve Bank of India to provide credit information about

commercial and consumer borrowers to a limited group of members, including banks,

financial institutions, non-banking financial companies, housing finance companies and

credit card companies.

In the United States, a credit score is a number based on a statistical analysis of a person's

credit files, that in theory represents the creditworthiness of that person, which is the

likelihood that people will pay their bills. A credit score is primarily based on credit

report information, typically from one of the three major credit

bureaus: Experian, TransUnion, and Equifax. Income is not considered by the major credit

bureaus when calculating a credit score.

There are different methods of calculating credit scores. FICO, the most widely known type

of credit score, is a credit score developed by FICO, previously known as Fair Isaac

Corporation. It is used by many mortgage lenders that use a risk-based system to determine

the possibility that the borrower may default on financial obligations to the mortgage lender.

All credit scores have to be subject to availability. The credit bureaus all have their own

credit scores: Equifax's ScorePower, Experian's PLUS score, and TransUnion's credit score,

and each also sells the VantageScore credit score. In addition, many large lenders,

including the major credit card issuers, have developed their own proprietary scoring

models.

Studies have shown scores to be predictive of risk in the underwriting of both credit and

insurance. Some studies even suggest that most consumers are the beneficiaries of lower

credit costs and insurance premiums due to the use of credit scores.

Usage of credit histories in employment screenings has increased from 19% in 1996 to 42%

in 2006. However, credit reports for employment screening purposes do not include credit

scores.

Americans are entitled to one free credit report within a 12-month period from each of the

three credit bureaus, but are not entitled to receive a free credit score. Credit scores are

available as an add-on feature of the report for a fee. This fee is usually around $10, as the

FTC regulates this charge, and the credit bureaus are not allowed to charge an exorbitant

fee for their credit score. If the consumer disputes an item on a credit report obtained using

the free system, under the Fair Credit Reporting Act (FCRA), the credit bureaus have 45

days to investigate, rather than 30 days for reports obtained otherwise.

Alternatively, consumers wishing to obtain their credit scores can in some cases purchase

them separately from the credit bureaus or can purchase their FICO score directly from Fair

Isaac. Under the Fair Credit Reporting Act, a consumer is entitled to a free credit report (but

not a free credit score) within 60 days of any adverse action (e.g. being denied credit, or

receiving substandard credit terms from a lender) taken as a result of their credit score.

Under the Wall Street reform bill passed on July 22, 2010, a consumer is entitled to receive

a free credit score if they are denied a loan or insurance due to their credit score.


The FICO credit score ranges between 300 and 850. The VantageScore score ranges from

501-990

Credit Information Bureau (India) Limited (Cibil) will now provide customers their credit

reports and scores online for Indians too. Individuals can now access these through a three-

step process. In the first step, customers would have to fill an online form, with personal

details like name, licence number and contact details. The second step would involve a

payment of Rs 450, by way of debit, credit cards, net banking or cash cards. The third step

would involve authentication and this would pose five system-generated questions. To prove

their authenticity, customers would have to answer at least three questions. The questions

would be objective, and would also carry a few options. The questions would be very

personal, and can be answered only by real customers. In case the customer fails to answer

three questions correctly, he/she would have to go through the normal procedure of sending

the hard copy of the documents to complete the know-your-client procedure. Also, while the

normal procedure of report generation by Cibil allows customers to pay Rs 142 and just get

the report without the score, the online procedure does not provide this option, and the

customers would have to pay Rs 450.

What are credit Ratings:

Credit ratings are forward looking: As part of its ratings analysis, Standard & Poor’s

evaluates available current and historical information and assesses the potential impact of

foreseeable future events. For example, in rating a corporation as an issuer of debt, the agency

may factor in anticipated ups and downs in the business cycle that may affect the

corporation’s creditworthiness. While the forward looking opinions of rating agencies can be

of use to investors and market participants who are making long- or short-term investment

and business decisions, credit ratings are not a guarantee that an investment will pay out or

that it will not default.

Credit ratings do not indicate investment merit: While investors may use credit

ratings in making investment decisions, Standard & Poor’s ratings are not indications of

investment merit. In other words, the ratings are not buy, sell, or hold recommendations, or a

measure of asset value. Nor are they intended to signal the suitability of an investment. They

speak to one aspect of an investment decision— credit quality—and, in some cases, may

also address what investors can expect to recover in the event of default.

In evaluating an investment, investors should consider, in addition to credit quality, the

current make-up of their portfolios, their investment strategy and time horizon, their

tolerance for risk, and an estimation of the security’s relative value in comparison to other

securities they might choose. By way of analogy, while reputation for dependability may be

an important consideration in buying a car, it is not the sole criterion on which drivers

normally base their purchase decisions.

Credit ratings are not absolute measures of default probability: Since there are

future events and developments that cannot be foreseen, the assignment of credit ratings is

not an exact science. For this reason, Standard & Poor’s ratings opinions are not intended

as guarantees of credit quality or as exact measures of the probability that a particular issuer

or particular debt issue will default.


Instead, ratings express relative opinions about the creditworthiness of an issuer or credit

quality of an individual debt issue, from strongest to weakest, within a universe of credit

risk. For example, a corporate bond that is rated ‘AA’ is viewed by the rating agency as

having a higher credit quality than a corporate bond with a ‘BBB’ rating. But the ‘AA’ rating

isn’t a guarantee that it will not default, only that, in the agency’s opinion, it is less likely to

default than the ‘BBB’ bond.

Corporate credit ratings

The credit rating of a corporation is a financial indicator to potential investors

debt securities such as bonds. Credit rating is usually of a financial instrument such as a

bond, rather than the whole corporation. These are assigned by credit rating agencies such

as A. M. Best, Dun & Bradstreet, Standard & Poor's, Moody's or Fitch Ratings and have

letter designations such as A, B, C. The Standard & Poor's rating scale is as follows, from

excellent to poor: AAA, AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB-, BB+, BB, BB-, B+, B, B-

, CCC+, CCC, CCC-, CC, C, D. Anything lower than a BBB- rating is considered a

speculative or junk bond. The Moody's rating system is similar in concept but the naming is

a little different. It is as follows, from excellent to poor: Aaa, Aa1, Aa2, Aa3, A1, A2, A3,

Baa1, Baa2, Baa3, Ba1, Ba2, Ba3, B1, B2, B3, Caa1, Caa2, Caa3, Ca, C.

A. M. Best rates from excellent to poor in the following manner: A++, A+, A, A-, B++, B+, B,

B-, C++, C+, C, C-, D, E, F, and S. The CTRISKS rating system is as follows: CT3A, CT2A,

CT1A, CT3B, CT2B, CT1B, CT3C, CT2C and CT1C. All these CTRISKS grades are

mapped to one-year probability of default.

Moody's S&P Fitch

Long-

term

Short-

term

Long-

term

Short-

term

Long-

term

Short-

term

Aaa

P-1

AAA

A-1+

AAA

F1+

Prime

Aa1 AA+ AA+

High grade Aa2 AA AA

Aa3 AA- AA-

http://en.wikipedia.org/wiki/Security_(finance)

http://en.wikipedia.org/wiki/A._M._Best

http://en.wikipedia.org/wiki/Dun_%26_Bradstreet

http://en.wikipedia.org/wiki/Standard_%26_Poor%27s

http://en.wikipedia.org/wiki/Moody%27s

http://en.wikipedia.org/wiki/Fitch_Ratings


A1 A+

A-1

A+

F1

Upper medium

grade A2 A A

A3

P-2

A-

A-2

A-

F2

Baa1 BBB+ BBB+

Lower medium

grade Baa2

P-3

BBB

A-3

BBB

F3

Baa3 BBB- BBB-

Ba1

Not prime

BB+

B

BB+

B

Non-investment

grade

speculative

Ba2 BB BB

Ba3 BB- BB-

B1 B+ B+

Highly speculative B2 B B

B3 B- B-

Caa1 CCC+

C CCC C

Substantial risks

Caa2 CCC Extremely

speculative


Caa3 CCC-

In default with little

prospect for

recovery Ca

CC

C

C

D /

DDD

/ In default / DD

/ D

Sovereign credit ratings

AAA

AA

A

BBB

BB

B

CCC

no rating

A sovereign credit rating is the credit rating of a sovereign entity, i.e., a national

government. The sovereign credit rating indicates the risk level of the investing environment

of a country and is used by investors looking to invest abroad. It takes political risk into

account.

Country risk rankings (June 2011)

Rank Previous Country Overall score


1 1 Norway 92.44

2 6 Luxembourg 90.86

3 2 Switzerland 90.20

4 4 Denmark 89.07

5 3 Sweden 88.72

6 12 Singapore 87.65

7 5 Finland 87.31

8 7 Canada 87.24

9 6 Netherlands 86.97

10 13 Germany 85.73

The table shows the ten least-risky countries for investment as of June 2011. Ratings are

further broken down into components including political risk, economic risk. Euromoney's bi-

annual country risk index monitors the political and economic stability of 185 sovereign

countries. Results focus foremost on economics, specifically sovereign default risk and/or

payment default risk for exporters (a.k.a. "trade credit" risk).

A. M. Best defines "country risk" as the risk that country-specific factors could

adversely affect an insurer's ability to meet its financial obligations.

Short-term rating

A short-term rating is a probability factor of an individual going into default within a year.

This is in contrast to long-term rating which is evaluated over a long timeframe. In the past

institutional investors preferred to consider long-term ratings. Nowadays, short-term ratings

http://en.wikipedia.org/wiki/Finland

http://en.wikipedia.org/wiki/Canada

http://en.wikipedia.org/wiki/Netherlands

http://en.wikipedia.org/wiki/Germany


are commonly used. First, the Basel II agreement requires banks to report their one-year

probability if they applied internal-ratings-based approach for capital requirements. Second,

many institutional investors can easily manage their credit/bond portfolios with derivatives

on monthly or quarterly basis. Therefore, some rating agencies simply report short-term

ratings.

In addition, the Guide to Credit Rating Essentials points out several key

things you should know about credit ratings: Credit ratings are opinions about relative credit risk. Credit ratings are not investment advice, or buy, hold, or sell recommendations. They

are just one factor investors may consider in making investment decisions.

Credit ratings are not indications of the market liquidity of a debt security or its price in

the secondary market.

Credit ratings are not guarantees of credit quality or of future credit risk.

Credit Ratings are opinions based on analysis by experienced professionals who evaluate

and interpret information received from issuers and other available sources to form a

considered opinion.

Unlike other types of opinions, such as, for example, those provided by doctors or lawyers,

credit ratings opinions are not intended to be a prognosis or recommendation. Instead, they

are primarily intended to provide investors and market participants with information about

the relative credit risk of issuers and individual debt issues that the agency rates.

Why credit ratings are useful Credit ratings may play a useful role in enabling corporations and governments to raise

money in the capital markets. Instead of taking a loan from a bank, these entities

sometimes borrow money directly from investors by issuing bonds or notes. Investors

purchase these debt securities, such as municipal bonds, expecting to receive interest plus

the return of their principal, either when the bond matures or as periodic payments.

Credit ratings may facilitate the process of issuing and purchasing bonds and other debt

issues by providing an efficient, widely recognized, and long-standing measure of relative

credit risk. Investors and other market participants may use the ratings as a screening device

to match the relative credit risk of an issuer or individual debt issue with their own risk

tolerance or credit risk guidelines in making investment and business decisions.

For instance, in considering the purchase of a municipal bond, an investor may check to

see whether the bond’s credit rating is in keeping with the level of credit risk he or she is

willing to assume. At the same time, credit ratings may be used by corporations to help

them raise money for expansion and/or research and development as well as help states,

cities, and other municipalities to fund public projects.


Who uses credit ratings

Investors Investors most often

use credit ratings to help assess

credit risk and to compare

different issuers and debt issues

when making

investment decisions and managing

their portfolios. Individual investors,

for example, may use credit ratings in

evaluating the purchase of a

municipal or corporate bond from

a risk tolerance perspective.

Institutional investors, including

mutual funds, pension funds, banks,

and insurance companies often use credit ratings to supplement their

own credit analysis of specific debt

issues. In addition, institutional

investors may use credit ratings to

establish thresholds for credit risk and

investment guidelines.

A rating may be used as an indication

of credit quality, but investors

should consider a variety of factors,

including their own analysis.

Intermediaries Investment bankers help to facilitate

the flow of capital from investors to

issuers. They may use credit ratings

to benchmark the relative credit risk

of different debt issues, as well as to

set the initial pricing for individual

debt issues they structure and to help

determine the interest rate these

issues will pay.

Investment bankers and entities that

structure special types of debt issues

may look to a rating agency’s criteria

when making their own decisions

about how to configure different debt

issues, or different tiers of debt.

Investment bankers may also serve as arrangers of special debt issues. In

this capacity, they establish special

entities that package assets, such as

retail mortgages and student loans,

into securities, or structured finance

instruments, which they then market

to investors.


Credit rating agencies

Some credit rating agencies, including major global agencies like Standard & Poor’s, are publishing

and information companies that specialize in analyzing the credit risk of issuers and individual debt

issues. They formulate and disseminate ratings opinions that are used by investors and other

market participants who may consider credit risk in making their investment and business

decisions. In part because rating agencies are not directly involved in capital market transactions,

they have come to be viewed by both investors and issuers as impartial, independent providers of

opinions on credit risk.

Businesses and financial institutions

Businesses and financial institutions, especially those involved in credit- sensitive transactions,

may use credit ratings to assess counterparty risk, which is the potential risk that a party to a credit

agreement may not fulfill its obligations. For example, in deciding whether to lend money to a

particular organization or in selecting a company that will guarantee the repayment of a debt issue

in the event of default, a business may wish to consider the counterparty risk. A credit rating

agency’s opinion of counterparty risk can therefore help businesses analyze their credit exposure

to financial firms that have agreed to assume certain financial obligations and to evaluate the

viability of potential partnerships and other business relationships.

Issuers

Issuers, including corporations, financial institutions, national governments, states, cities and

municipalities, use credit ratings to provide independent views of their creditworthiness and the

credit quality of their debt issues.Issuers may also use credit ratings to help communicate the

relative credit quality of debt issues, thereby expanding the universe of investors. In addition, credit

ratings may help them anticipate the interest rate to be offered on their new debt issues.As a

general rule, the more creditworthy an issuer or an issue is, the lower the interest rate the issuer

would typically have to pay to attract investors. The reverse is also true: an issuer with lower

creditworthiness will typically pay a higher interest rate to offset the greater credit risk assumed by

investors.

Rating methodologies In forming their opinions of credit risk, rating agencies typically use primarily analysts or

mathematical models, or a combination of the two.

Model driven ratings. A small number of credit rating agencies focus almost exclusively on

quantitative data, which they incorporate into a mathematical model. For example, an agency using

this approach to assess the creditworthiness of a bank or other financial institution might evaluate

that entity’s asset quality, funding, and profitability based primarily on data from the institution’s

public financial statements and regulatory filings.

Analyst driven ratings. In rating a corporation or municipality, agencies using the analyst driven

approach generally assign an analyst, often in conjunction with a team of specialists, to take the

lead in evaluating the entity’s creditworthiness. Typically, analysts obtain information from

published reports, as well as from interviews and discussions with the issuer’s management. They

use that information to assess the entity’s financial condition, operating performance, policies, and

risk management strategies.

How agencies are paid for their services

Agencies typically receive payment for their services either from the issuer that requests the rating

or from subscribers who receive the published ratings and related credit reports.

Issuer-pay model. Under the issuer-pay model, rating agencies charge issuers a fee for providing a

ratings opinion. In conducting their analysis, agencies may obtain information from issuers that


might not otherwise be available to the public and factor this information into their ratings opinion.

agency does not rely solely on subscribers for fees, it can publish current ratings broadly to the

public free of charge.

Subscription model. Credit rating agencies that use a subscription model charge investors and

other market participants a fee for access to the agency’s ratings. Critics point out that like the

issuer-pay model, this model has the potential for conflicts of interest since the entities paying for

the rating, in this case investors, may attempt to influence the ratings opinion.

Critics of this model also point out that the ratings are available only to paying subscribers. These

tend to be large institutional investors, leaving out smaller investors, including individual investors.

In addition, rating agencies using the subscription model may have more limited access to issuers.

Information from management can be helpful when providing forward looking ratings.

Safeguards for issuer-pay ratings

To protect against potential conflicts of interest when paid by the issuer, Standard & Poor’s has

established a number of safeguards. These measures include, for example, a clear separation of

function between those who negotiate the business terms for the ratings assignment and the

analysts who conduct the credit analysis and provide the ratings opinions. This separation is similar

in concept to the way newspapers distinguish their editorial and advertising sales functions, since

they report on companies from which they may also collect advertising fees. Another safeguard is

the committee process that limits the influence any single person can have on Standard & Poor’s

ratings opinions. The role of the committee is to review and assess the analyst’s recommendation

for a new rating or a ratings change as well as to provide additional perspectives and checks and

balances regarding adherence to the agency’s ratings criteria.

Rating issuers and issues

Credit rating agencies assign ratings to issuers, such as corporations and governments, as well as

to specific debt issues, such as bonds, notes, and other debt securities.

Rating an issuer To assess the creditworthiness of an issuer, Standard & Poor’s evaluates the

issuer’s ability and willingness to repay its obligations in accordance with the terms of those

obligations.

To form its ratings opinions, Standard & Poor’s reviews a broad range of financial and business

attributes that may influence the issuer’s prompt repayment. The specific risk factors that are

analyzed depend in part on the type of issuer.

For example, the credit analysis of a corporate issuer typically considers many financial and non-

financial factors, including key performance indicators, economic, regulatory, and geopolitical

influences, management and corporate governance attributes, and competitive

position. In rating a sovereign, or national government, the analysis may concentrate on political

risk, monetary stability, and overall debt burden.

For high-grade credit ratings, Standard & Poor’s considers the anticipated ups and downs of the

business cycle, including industry-specific and broad economic factors. The length and effects of

business cycles can vary greatly, however, making their impact on credit quality difficult to predict

with precision. In the case of higher risk, more volatile speculative- grade ratings, Standard &

Poor’s factors in greater vulnerability to down business cycles.

Rating an issue In rating an individual debt issue, such as a corporate or municipal bond, Standard

& Poor’s typically uses, among other things, information from the issuer and other sources to

evaluate the credit quality of the issue and the likelihood of default. In the case of bonds issued by

corporations or municipalities, rating agencies typically begin with an evaluation of the

creditworthiness of the issuer before assessing the credit quality of a specific debt issue.

In analyzing debt issues, for example, Standard & Poor’s analysts evaluate, among other things:


> The terms and conditions of the debt security and, if relevant, its legal structure.

> The relative seniority of the issue with regard to the issuer’s other debt issues and priority of

repayment in the event of default.

> The existence of external support or credit enhancements, such as letters of credit, guarantees,

insurance, and collateral. These protections can provide a cushion that limits the potential credit

risks associated with a particular issue.

Recovery of investment after default

Credit rating agencies may also assess recovery, which is the likelihood that investors will recoup

the unpaid portion of their principal in the event of default. Some agencies incorporate recovery as

a rating factor in evaluating the credit quality of an issue, particularly in the case of non-investment-

grade debt. Other agencies, such as Standard & Poor’s, issue recovery ratings in addition to rating

specific debt issues. Standard & Poor’s may also consider recovery ratings in adjusting the credit

rating of a debt issue up or down in relation to the credit rating assigned to the issuer.

Rating structured finance instruments A structured finance instrument is a particular type of debt

issue created through a process known as securitization. In essence, securitization involves

pooling individual financial assets, such as mortgage or auto loans,

and creating, or structuring, separate debt securities that are sold to investors to fund the purchase

of these assets.

The creation of structured finance instruments, such as residential mortgage-backed securities

(RMBS), asset-backed securities (ABS), and collateralized debt obligations (CDOs), typically

involves three parties: an originator, an arranger, and a special purpose entity, or SPE, that issues

the securities.

> The originator is generally a bank, lender, or a financial intermediary who either makes loans to

individuals or other borrowers or purchases the loans from other originators.

> The arranger, which may also be the originator, typically an investment bank or other financial

services company, securitizes the underlying loans as marketable debt instruments.

> The special purpose entity (SPE), generally created by the arranger, finances the purchase of the

underlying assets by selling debt instruments to investors. The investors are repaid with the cash

flow from the underlying loans or other assets owned by the SPE.

Stratifying a pool of undifferentiated risk into multiple classes of bonds with varying levels of

seniority is called tranching. Investors who purchase the senior tranche, which generally has the

highest quality debt from a credit perspective and the lowest interest rate, are the first to be repaid

from the cash flow of the underlying assets. Holders of the next-lower tranche, which pays a

somewhat higher rate, are paid second, and so forth. Investors who purchase the lowest tranche

generally have the potential to earn the highest interest rate, but they also tend to assume the

highest risk.

In forming its opinion of a structured finance instrument, Standard & Poor’s evaluates, among other

things, the potential risks posed by the instrument’s legal structure and the credit quality of the

assets the SPE holds. Standard & Poor’s also considers the anticipated cash flow of these

underlying assets and any credit enhancements that provide protection against default.

Expressions of change: Outlook and CreditWatch

If Standard & Poor’s anticipates that a credit rating may change in the coming 6 to 24 months, it

may issue an updated ratings outlook indicating whether the possible change is likely to be

“positive,” “negative,” “stable,” or “developing” (meaning it’s uncertain whether a rating might go up

or down). Or, if events or circumstances occur that may affect a credit rating in the near term,

usually within 90 days, Standard & Poor’s may place the rating on CreditWatch. Typically, an

updated outlook or CreditWatch from Standard & Poor’s includes a rationale for the potential


change and the extent of the change, up or down, that may occur. However, updating a ratings

outlook or placing a rating on CreditWatch does not mean a ratings change is inevitable.

If Standard & Poor’s has all the information available to warrant a ratings change, it may upgrade or

downgrade the rating immediately, without placing the rating on CreditWatch or changing its

outlook, to reflect these circumstances and its current opinion of relative credit risk.

Surveillance: Tracking credit quality Agencies typically track developments that might affect the

credit risk of an issuer or individual debt issue for which an agency has provided a ratings opinion.

In the case of Standard & Poor’s, the goal of this surveillance is to keep the rating current by

identifying issues

that may result in either an upgrade or a downgrade. In conducting its surveillance, Standard &

Poor’s may consider many factors, including, for example, changes in the business climate or credit

markets, new technology or competition that may hurt an issuer’s earnings or projected revenues,

issuer performance, and regulatory changes. The frequency and extent of surveillance typically

depends on specific risk. considerations for an individual issuer or issue, or an entire group of rated

entities or debt issues. In its surveillance of a corporate issuer’s ratings, for example, Standard &

Poor’s may schedule periodic meetings with a company to allow management to:

> Apprise agency analysts of any changes in the company’s plans.

> Discuss new developments that may affect prior expectations of credit risk.

> Identify and evaluate other factors or assumptions that may affect the agency’s opinion of the

issuer’s creditworthiness.

As a result of its surveillance analysis, an agency may adjust the credit rating of an issuer or issue

to signify its view of a higher or lower level of relative credit risk.

Why credit ratings change

The reasons for ratings adjustments vary, and may be broadly related to overall shifts in the

economy or business environment or more narrowly focused on circumstances affecting a specific

industry, entity, or individual debt issue.

In some cases, changes in the business climate can affect the credit risk of a wide array of issuers

and securities. For instance, new competition or technology, beyond what might have been

expected and factored into the ratings, may hurt a company’s expected earnings performance,

which could lead to one or more rating downgrades over time.

Growing or shrinking debt burdens, hefty capital spending requirements, and regulatory changes

may also trigger ratings changes. While some risk factors tend to affect all issuers—an example

would be growing inflation that affects interest rate levels and the cost of capital—other risk factors

may pertain only to a narrow group of issuers and debt issues. For instance, the creditworthiness of

a state or municipality may be impacted by population shifts or lower incomes of taxpayers, which

reduce tax receipts and ability to repay debt.

When ratings change

Credit rating adjustments may play a role in how the market perceives a particular issuer or

individual debt issue. Sometimes, for example, a downgrade by a rating agency may change the

market’s perception of the credit risk of a debt security which, combined with other factors, may

lead to a change in the price of that security.

Market prices continually fluctuate as investors reach their own conclusions about the security’s

shifting credit quality and investment merit. While ratings changes may affect investor perception,

credit ratings constitute just one of many factors that the marketplace should consider when

evaluating debt securities.

Agency studies of defaults and ratings changes

To measure the performance of its credit ratings, Standard & Poor’s conducts studies to track


default rates and transitions, which is how much a rating has changed, up or down, over a certain

period of time. Agencies use these studies to refine and evolve their analytic methods in forming

their ratings opinions.

Transition rates can also be helpful to investors and credit professionals

because they show the relative stability and volatility of credit ratings. For example, investors who

are obligated to purchase only highly rated securities and are looking for some indication of stability

may review the history of rating transitions and defaults as part of their investment research.

Introduction of Corporate Valuation techniques The corporate finance theories and practices have evolved since the 50’s from normative to

positive approaches to explain why and how investors react to companies’ decisions and

announcements with respect to companies’ financial and investment decisions. The ways and

the empirical examination provides varying results because different variables suggest

different estimates of expected future cash flows and, thus, different market value.

The most basic of these models can be written as follows.


The discounted cash flow formula is derived from the future value formula for calculating the time

value of money and compounding returns.

Thus the discounted present value (for one cash flow in one future period) is expressed as:

where

DPV is the discounted present value of the future cash flow (FV), or FV adjusted for the delay in

receipt;

FV is the nominal value of a cash flow amount in a future period;

i is the interest rate, which reflects the cost of tying up capital and may also allow for the risk that

the payment may not be received in full;

d is the discount rate, which is i/(1+i), i.e. the interest rate expressed as a deduction at the

beginning of the year instead of an addition at the end of the year;

n is the time in years before the future cash flow occurs.

Theoretically this model has been extended to fit the believed lifecycle of the company.

In this way the theory can account for different growth rates in the infancy of the company, the

“maturity " stage of the company, and the decay of the company. The assumption of constant cost

of capital over a longer period of time reflects the simplification of the companies’ values.

The Gordon growth model is a variant of the discounted cash flow model, a method for valuing

a stock or business. Often used to provide difficult-to-resolve valuation issues for litigation, tax

planning, and business transactions that don't have an explicit market value. It is named after Myron

J. Gordon, who originally published it in 1959. It assumes that the company issues a dividend that has

a current value of D that grows at a constant rate g. It also assumes that the required rate of return for

the stock remains constant at k>g which is equal to the cost of equity for that company. It involves

summing the infinite series which gives the value of price current P.

.

Summing the infinite series we get,

，

In practice this P is then adjusted by various factors e.g. the size of the company.

，

k denotes expected return = yield + expected growth.


It is common to use the next value of D given by : D1 = D0(1 + g), thus the Gordon's

model can be stated as

.

Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model postulates a simple linear relationship between

expected rate of return and systematic risk of a security or portfolio. The model is an

extension of Markowitz’s (1952) portfolio theory. The researchers who are commonly

credited with the development of CAPM are Sharpe (1964), Linter (1965) and Black (1972),

which is why CAPM is commonly referred to as SLB model.

Markowitz (1952) developed a concept of portfolio efficiency in terms of the

combination of risky assets that minimizes the risk for a given return or maximizes return

for a given risk. Using variance of expected returns as the measure of risk, he shows a

locus of efficient portfolios that minimize risk for a given rate of return.

The Capital Asset Pricing Model equation shows the relationship between cost of

capital and market returns and takes the following form,

E(Ri) = Rf + i (E (RM)- Rf) Where: E is the expectation operator;

Ri is the return on equity or portfolio i; RM is the return on the market portfolio; Rf of the risk-free asset;

i is a measure of systematic risk on equity or portfolio i. The equation indicates that the expected rate of return on asset i is equal to the rate of return

on the risk-free asset plus a risk premium. This is simply a multiple () of the difference

between the expected rate of the return of the market portfolio and the risk-free rate.

Arbitrage Pricing Theory (APT)

Arbitrage Pricing Theory (APT), developed by Ross (1976), suggests that value return

depend on several independent factors rather than a single factor of systematic risk. When

these types of models include beta from CAPM they are sometime referred to as extended

CAPM. When beta is excluded they are simply called Arbitrage Pricing Models (APM). A

major criticism of these models is that there is no theory to suggest which variables should be

included and which variables excluded, and therefore the choice of variables in the past has

been at ad- hoc.

Ri-Rf=ai + t(RM -Rf,)+si(SMB)


RM is market return. Rf is the risk-free rate. SML is constructed by taking the return of a portfolio of companies in the bottom 50

percentile by market capitalization minus the return of a portfolio of companies in the top

50 percentile by market capitalization.

Weighted Average Cost of Capital (WACC)

Miller and Modigliani (1958, 1963) demonstrated that the value of a company would

be unaffected by either capital structure or dividend policy in the absence of taxes. Once

corporate taxes are introduced the capital structure can influence the value of the company.

Since interest payments can be deducted, the cost of external financing becomes cheaper. The

assumptions used are similar to that of the frictionless world of CAPM, namely perfect

information and perfect capital markets. The relevant formulas of the model are as follows

Kto t Ke (1 t ) D/E( Ke Kd ) Where:

Ktot is the total cost of capital for the company; Ke is the cost of capital of equity;

Kd is the cost of capital of debt; D is the value of debt;

E is the value of equity;

WACCtot is the total weighted cost of capital for the entire company; and

WACCe is the weighted cost of capital if the company did not incur debt.

Therefore, the value to equity holders will increase by a greater amount when the company

incurs debt to finance new projects as compared to the use of internal finance or the issuance

of new equity. In addition, the value to any existing debt holder will decrease with the

issuance of new debt by the company.

Investment Models

The neo-classical model of investment is based on an explicit model of optimization

that relates the desired capital stock to interest rates, output, capital assets and tax policies.

The model assumes efficient capital markets and perfect information. All companies have

equal access to capital markets regardless of risk, therefore the amount borrowed and the cost

of capital will only differ because of difference in investment demand. Irvin Fischer (1930)

presents a more in-depth discussion of this model in his book the Theory of Interest. A

summary of the theory and an empirical investigation can be found in Jorgenson (1963).

Tobin (1969) developed an investment demand model in which net investment


depends on the ratio of the market value of an asset to its replacement cost. The replacement

cost is represented by a "q" ratio, which is why this model is generally referred to as Tobin's q

Model of Investment. This model suggests that the company will continue to invest as long

as the market value of the marginal unit of capital exceeds its costs. This leads to an

investment model for the company in the following form:

It a ￥ b j ( q 1) t j Kt j 1 bk Kt 1 u j 0

Where:

It is the investment expenditure at time t; Kt-1 is the capital stock at time t-1;

Kt-j-1 is the capital stock at time t-j-1;

a, bj and bk and coefficients;

q is Tobin's q ratio.

Conclusion: Why Credit Ratings Are Still Important in Determining Stock Valuation

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. 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 we use (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, for us, EBITDA is not part of the credit worksheet

as we focus on free cash flow, including serious adjustments to published financial statements. Also,

S&P defines free operating cash flow as cash flow from operating activities minus capital spending.

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 our credit worksheet when a rating change

is most likely.

Table 1

Key Financial Ratios Standard and Poor’s:


Table 2

Intel Implied Credit Based On S&P Key Metrics

Using metrics from S&P Key Financial Ratios (Table 1), we look at Intel in Table 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. The data in tables 2, 3 and 4 are from published financial statements gathered by Research

Insight, a division of S&P.


Bibliography:

1.) http://seekingalpha.com/article/228415-why-credit-ratings-are-still-important-in-determining-stock-valuation

2.) http://library.witpress.com/pages/PaperInfo.asp?PaperID=16488

3.) http://en.wikipedia.org/wiki/Gordon_model

4.) http://en.wikipedia.org/wiki/Credit_rating

5.) http://pages.stern.nyu.edu/~adamodar/

6.) http://www.investopedia.com/articles/financial-theory/11/corporate-project-valuation-methods.asp

7.) http://www.investopedia.com

http://seekingalpha.com/article/228415-why-credit-ratings-are-still-important-in-determining-stock-valuation

http://seekingalpha.com/article/228415-why-credit-ratings-are-still-important-in-determining-stock-valuation

http://library.witpress.com/pages/PaperInfo.asp?PaperID=16488

http://en.wikipedia.org/wiki/Gordon_model

http://en.wikipedia.org/wiki/Credit_rating

http://pages.stern.nyu.edu/~adamodar/

http://www.investopedia.com/articles/financial-theory/11/corporate-project-valuation-methods.asp

http://www.investopedia.com/articles/financial-theory/11/corporate-project-valuation-methods.asp

http://www.investopedia.com/

a literature review of concepts of credit ratings and corporate valuation

Documents

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