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A More Powerful Bankruptcy Prediction Model

Distance to Default does a better job than traditional methods of gauging a company's financial health.

Warren Miller, James P. Harrington, and Magdalena Mroczek, 01/12/2010

In light of ongoing economic turmoil and continuing uncertainty in credit markets, it's more important than ever for investors to accurately identify companies in distress and their potential for default. Morningstar's Financial Health Grade, a data point available across Morningstar's equity research products, is a way for investors to quickly do just that.

The grade is based upon Morningstar's Distance to Default methodology, a slightly modified structural model similar to those created by Black, Scholes, and Merton.Distance to Default takes advantage of both market information and accounting financial information to estimate companies' probability of (or "distance" to) default. Every day, Morningstar calculates Distance to Default values for the universe of U.S. stocks and then ranks these values and awards Financial Health Grades to each company: The most-healthy 10% of the universe earn A's, the next 20% get B's, the next 40% earn C's, the next 20% get D's, and the bottom 10% get F's.

(View the related graphic here.)

Recently, Morningstar's valuation research team re-examined Distance to Default and another bankruptcy prediction model-the Z-Score-to assess their predictive power. Under the extreme conditions of the financial crisis, are these models proving their mettle?

The Models
The Z-Score, developed by Edward Altman, a professor of finance at New York University, is perhaps the most familiar model for predicting financial distress (Bemmann 2005). Altman identified five common accounting ratios that significantly predict default. The five pillars are combined in an equation that result in a company's Z-Score (Altman 2002).

(View the related graphic here.)

Each factor is intuitively appealing to investors because it captures a different credit-relevant aspect of a company's operations. Liquidity, cumulative profitability, asset productivity, market-based financial leverage, and capital turnover are addressed by the five ratios. The Z-Score presumes that each ratio is linearly related to a company's probability of bankruptcy.

Morningstar's Distance to Default model is less intuitive than the Z-Score because it does not specifically address the cash accounting values that practitioners and professionals typically examine in a default or bankruptcy. The Distance to Default model considers a company's equity as a call option on the firm's assets with a strike price equal to the book value of its liabilities and a market price equal to the market value of the firm's assets. Distance to Default describes the probability that this hypothetical call option will end up worthless-in effect, the potential that it will default if the value of the firm's assets drops below the book value of the firm's liabilities.

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