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James Li
James Li
Articles (339)  | Author's Website |

New Calculation: The Probability of Financial Distress

A new method for computing bankruptcy risk

December 05, 2017 | About:

We are pleased to announce a new method of computing the bankruptcy risk of companies, the “Probability of Financial Distress.”

Background

John Campbell, Jens Hilscher and Jan Szilagyi developed a logit probability model based on eight explanatory variables:

  1. Net income to market total assets (NIMTAAVG).
  2. Total liabilities to market total assets (TLMTA).
  3. Cash to market total assets (CASHMTA).
  4. Excess return compared to the S&P 500 (EXRETAVG).
  5. Standard deviation of daily returns over the past three months (SIGMA).
  6. Relative size (RSIZE).
  7. Market-to-book equity ratio (MB).
  8. The log of the stock price, capped at log(15) (PRICE).

The logit formula to compute the probability of financial distress (PFD) is given below:

LPFD = -20.12 * NIMTAAVG + 1.60 * TLMTA – 7.88 * EXRETAVG + 1.55 * SIGMA – 0.005 * RSIZE – 2.27 * CASHMTA + 0.070 * MB – 0.09 * PRICE – 8.87

To compute the PFD, we take the ratio of exp (LPFD) to 1 plus exp (LPFD), where “exp” stands for the exponential function. This PFD measures the probability that a company will go bankrupt within the next 12 months given its current financial position.

Example calculation

Consider Apple Inc. (NASDAQ:AAPL), which currently has a PFD of approximately 0.02%.

Although most of the X variables have straightforward calculations, three of them require deeper calculations: NIMTAAVG, EXRETAVG and SIGMA.

For NIMTAAVG, we consider the net income over the market total assets over the past four quarters. Table 1 shows the NIMTA ratios of Apple for the past four quarters.

Quarter

Latest

2nd latest

3rd latest

4th latest

Net income

10714

8717

11029

17891

Market cap

796766.5

744551.72

749020.3

608960.7

Total liabilities

241272

212748

200450

198751

NIMTA

0.010321

0.0091058

0.011616

0.02215

Weight

0.5333

0.2666

0.1333

0.0666

Adjusted NIMTA

0.005504

0.0024276

0.001548

0.001475

Table 1: NIMTA Ratios for Apple, Past Four Quarters

We then take the sum of the adjusted NIMTA’s (last row of Table 1) to obtain 0.01095, the NIMTAAVG for Apple.

Note the “Weight” row in Table 1. According to the research paper, the NIMTAAVG is a “geometrically weighted average level of profitability where the weight is halved each quarter.” We compute the EXRETAVG in a similar way, i.e., we place more weight on the more recent returns. Table 2 illustrates the EXRETAVG calculation for Apple.

Month

EXRET

Factor

EXRETADJ

0

-0.03552

0.220053

-0.007816

1

0.102908

0.174656

0.017974

2

-0.10422

0.138625

-0.014447

3

0.055511

0.110026

0.006108

4

0.067974

0.087328

0.005936

5

-0.07853

0.069312

-0.005443

6

0.043868

0.055013

0.002413

7

-0.00742

0.043664

-0.000324

8

0.047817

0.034656

0.001657

9

0.043014

0.027507

0.001183

10

0.094222

0.021832

0.002057

11

-0.02874

0.017328

-0.000498

Table 2: Excess Returns (EXRET) for Apple, Past 12 Months

The “Month” column in Table 2 refers to Month m,  i.e., Month 0 refers to the current month and Month 1 refers to the previous month. The “Factor” column is constructed so the weight is halved each quarter. This means the weight for Month m is 2 ^ (-1/3) times the weight for Month m-1.

For sigma, we consider the annualized standard deviation of a company’s returns over the past 92 days (or 63 trading days). Figure 1 shows the exact formula for sigma according to the research paper.

Figure 1

The other calculations should be straightforward: the TLMTA is simply total liabilities over market total assets while CASHMTA is simply cash and equivalents over market total assets. For relative size, we take the log of market equity over the market value of the Standard & Poor’s 500 index. For the market-to-book value, we take the market equity over the adjusted book value of equity, which is the maximum value of one and the following sum: book equity plus one-tenth of the difference between market equity and book equity. Finally, we take the log of 15 or the company’s share price, whichever is lower.

Screening for companies based on PFD

You can screen for companies based on their PFD through our All-in-one Guru Screener. The PFD filter is located in the first column, under the Fundamental tab as illustrated in Figure 2.

Figure 2

You can screen for PFD in increments of 5% using the drop-down menus for “Probability of Financial Distress” shown in Figure 2 above. For example, the highlighted filter in Figure 3 screens for companies with, at most, a 15% probability of financial distress.

Figure 3

We also have the PFD filter in our Customized section if you wish to screen for companies with at most a 7% probability of financial distress. If you click on the Customized tab and then the blue “Create New Filter” button, you should see an Edit Filter Formula pop-up window like the one shown in Figure 4.

Figure 4

If you enter ‘Probability of Financial Distress (%)’ < 7 in the formula box, you will screen for companies that have no more than a 7% chance of going bankrupt within the next year.

How is the PFD different from the Altman Z-score?

Like the Altman Z-score, the PFD measures a company’s bankruptcy risk in the upcoming year. However, the main drawback of the Z-score is it does not apply to banks and insurance companies. According to Investopedia, the concept of “working capital” does not apply to banks like Bank of America Corp. (NYSE:BAC) as financial institutions do not have typical current assets or current liabilities like inventories or accounts payable.

See also

Premium members get full access to our value screeners, including the All-in-one Guru Screener. Premium Plus members get access to portfolio data on over 4,000 institutions that file 13Fs, up to 10 years of backtesting in the All-in-One Guru Screener, and the Manual of Stocks for all companies subscribed.

About the author:

James Li
I am an editorial assistant and researcher at GuruFocus. I have a Master's in Finance from SMU, and I enjoy writing reports on financial trends and investor portfolios. Follow me on Twitter at @JamesLiGuru!

Visit James Li's Website


Rating: 5.0/5 (4 votes)

Voters:

Comments

TaigaPilot
TaigaPilot premium member - 1 week ago

Is this new probability of financial distress calculation available yet in the financial strength section when I type the ticker symbol of a stock into the search bar? If it could be added there, near the Altman Z Score, it would be great.

James Li
James Li premium member - 1 week ago

Hi TaigaPilot,

We plan to add the PFD calculation to the financial strength section of a company's summary page. I will let people know when this is added.

Thanks!

algaar999
Algaar999 premium member - 5 days ago

How difficult would it be to include PFD in the prior year financials screen (and related xls download), so we can see how useful this metric has been as a predictor historically?

okkerse
Okkerse - 3 days ago    Report SPAM

Dear James,

As inventor of the OK-Score (since 2000 real life with a GINI of 98,6%) I can only wish you lot of success.

Please leave your comment:


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