In some case, it is very useful to have a corporate rating for each company (for example, if you need to estimate the cost of debt, you can use the risk free interest rate plus a credit spread depending of the corporate rating of the company). So, if you have this data from rating agencies such as Standard & Poors or Moody’s, it is perfect but in some case, the company for which you are looking for this rating is not rated by rating agencies and this can be a problem. In other case, the rating can be rather old and you are not sure it is still valid.
In our case, as we needed a corporate rating in order to estimate the weighted average cost of capital (WACC) of each company (major data when you build a discounted cash flow model), we decided to build our own scoring approach in order to rate each company in our universe.
What is the advantage of using our own rating methodology?
1. We are sure to have a rating for each company in our universe
2. We can update the data at any time. So, we are sure to have up to date information
3. Our rating is fully independent
4. We can score each company using our methodology (large caps and small & mid caps)
5. In order to deliver understandable information, we use the traditional scaling approach: from AAA (strong balance sheet and strong business) to B (weak balance sheet and weak business)
6. When we developed our methodology, 985 companies from our universe (1540 stocks) were covered by S&P. Our methodology delivered exactly the same rating than S&P for 211 companies (21%), 320 companies had a one notch difference (32%) and 239 companies had 2 notches difference. So, 770 companies (78% of our universe)had a rating difference of maximum 2 notches which is not bad when we consider we are not a rating agencies and that we don’t have thousands of employees working for us. On top of that, our target is to deliver an estimate and not ‘THE’ exact rating.
What is the major weakness of our methodology?
- Our ratings are automatically generated using an algorithm (based on reported data, consensus data, market data …). So, this approach can be less powerful than a human based approach when you have to rate companies in turnaround situation
- Due to the methodology we are using (mainly focused on cash flow, debt level, earnings and margins), financials have lower ratings in our approach than in the traditional ones (such as Standard & Poor’s and Moody’s). Nevertheless we feel comfortable with this situation because the Lehman Brothers crisis underlined the systemic risk and the domino effect in the sector. So, taking into account this characteristic, we consider it is normal to be strict with financials.