Thursday, July 7, 2011

implied default probability

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Funny what you can find on the Internet. I found a white-paper written in 2003 about Skechers (SKX) and it contained the same concerns then as there are today. Eight years later we are still starting another debate of where this company is in its life cycle. Is Skechers a badly managed mature company close to dying?

In valuation, there are several ways to determine how risky an asset is and the implied probability of default.

Looking at the market's interpretation of current sentiment and pricing
The easiest way is to look at the CDS, Futures & Swaps instruments for SKX. I couldn't find a free site and don't have access to asset-backed CDS equities information. If someone knows of one, please tell me.
[edit: a good website to gather information on equity default swaps is  here
The whole idea of these swaps are to hedge. If you knew that Ford was undervalued and Chrysler is overbought; you want to bet only on that, not the rest of the economy, etc. So you want to hedge the relationship of Ford to Chrysler not the rest of the world; Therefore special dynamic swaps are borne and only their creators'  imagination limit these models...don't ask me how they do it....I'm just figuring it out as I go here. ]

The alternative is to do it by hand. Wikipedia describes backward induction as the following:
Backward induction is the process of reasoning backwards in time, from the end of a problem or situation, to determine a sequence of optimal actions. It proceeds by first considering the last time a decision might be made and choosing what to do in any situation at that time. Using this information, one can then determine what to do at the second-to-last time of decision. This process continues backwards until one has determined the best action for every possible situation.
Using backward induction you can establish the present value of current equity prices and interest rates. That is how futures and swaps estimate their value and quantify uncertainty and risk. Dr. Geanakoplos has a free Yale University course on YouTube about this.

On to easier methods....

Looking at valuation methods 
Dr. Damodararian has many free spreadsheets that can give a valuation of the company.
-evaluation of debt/equity ratios to create a synthetic beta (implied equity risk premium)
-evaluation of debt bond ratings to create a synthetic credit rating

A little bit easier....

The quick calculation method
The Altman Z-score is an insolvency predictor. It can be viewed at several website, usually in their premium sections. I did find it for free here. There also is a Z-score calculator I used to generate historical scores. There are five financial ratios used in the Z-Score with different weight factors.

An article from Armand Lucarelli
"No model predicts precisely when failure will occur, but the Z-Score has indicated that failure is likely up to two years before a company declares bankruptcy. The Z-Score should be reviewed over time rather than at any one point in time. The trend is important. The most serious changes in the ratios occur between the third and second years prior to bankruptcy."

The Interpretation of Z Score

Using Yahoo finance data and the calculator above I generated the following historical Z-Scores:
For 2010 annual data SKX was 3.60
For 2009 annual data SKX was 3.99
For 2008 annual data SKX was 4.08
With a Z-Score above 3.0, a company is considered safe based on their financial ratios.

Armand Lucarelli continues
"The lower the Z-Score is, the greater the odds are of failure. For publicly owned companies, scores between 1.81 and 2.99 are in the gray area — a company may survive if corrective actions are taken — while scores of less than 1.81 indicate that failure is a real possibility. For privately owned companies, the range for the gray area is lower — 1.23 to 2.90 — to account for the differences between book value and market value."

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