A new measure to help investors assess the credit risk of companies.
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By Haywood Kelly, CFA | 12-02-09 | 08:00 AM | Email Article

We're pleased to announce the launch of Morningstar's corporate credit ratings.

These new ratings describe a company's creditworthiness relative to the broader universe of corporate borrowers. The higher the grade, the more capable we think the company is of fulfilling its obligations to bondholders in a timely manner. At the top end of the range, we award AAA ratings to a handful of firms: Exxon XOM, Johnson & Johnson JNJ, and Microsoft MSFT. These wide-moat companies have impeccable balance sheets and the ability to generate copious amounts of cash. You can find a full list of our initial credit ratings here.

Haywood Kelly, CFA, is vice president of equity research at Morningstar. He'd love to hear from you, and promises to read all your e-mail (even if he can't respond to it all).

We're launching with credit ratings on 100 companies. In selecting the 100 companies, we took a sample of companies from our coverage list from a variety of industries and a variety of credit profiles. Most are large firms with a significant amount of bonds outstanding. During the coming months, we'll be assigning ratings to more companies, prioritizing the big bond issuers that are most relevant to bond investors. By the time we're done, we plan to rate all significant bond issuers on our coverage list, which would be up to 1,000 global companies.

All of these ratings will be available (for free) on Morningstar.com. They will appear on the quote pages after you type in a stock ticker, such as , as well as on each company's bond summary page.

Our Approach to Rating Corporate Credit
If you're at all familiar with the way Morningstar analyzes companies, you'll recognize the key components to our credit rating methodology: the emphasis on economic moats and competitive analysis, the focus on the size and sustainability of free cash flows, and the assessment of the uncertainty surrounding a firm's operations and future profitability. In launching credit ratings, we're codifying work that we've been doing for years.

Just as our equity research methodology is forward-looking and based on fundamental company research, our credit rating methodology is prospective and focuses on our expectations of future cash flows. Our analysts build detailed models for each company they follow, and those models include five full years of forecasted proforma income statements, balance sheets, and cash-flow statements, as well as an explicit comparison of forecasted free cash flows versus debt and debt-like obligations. These models form an important underpinning to our credit ratings.

We give a detailed explanation of the mechanics of our credit rating process in our methodology documents (links to which we provide below), but we walk through the basics here.

For each company, we calculate four separate scores to help arrive at a credit rating.

  • We encapsulate our assessment of a firm's Economic Moat and other inherent business characteristics in a Business Risk Score.
  • Our Cash Flow CushionTM metric compares our projections of future cash flows to debt and other financial commitments.
  • The Solvency ScoreTM uses ratios of current financial performance that have shown a tendency to predict default before it actually occurs
  • Our Distance to Default metric uses option-pricing theory to appraise the risk that a firm's assets will turn out to be worth less than its liabilities.

Let's go through each component in more detail.

I. Business Risk
We consider seven elements in determining a firm's overall business risk, with the most weight put on the firm's Economic Moat and Uncertainty ratings.

Morningstar's Economic Moat RatingTM
The primary differentiating factor among firms is how long they can earn high returns on capital and hold competitors at bay. Only firms with economic moats � something structural in their business models that rivals cannot easily replicate � can stave off competitive forces for a prolonged period.

Uncertainty Rating
Morningstar's Uncertainty Rating represents our estimate of the predictability of future cash flows. Because equity is the residual value of a firm, it represents the cushion in the capital structure for bond holders.

Size
The larger a company's revenue base, the greater its resilience (other things equal), especially during periods of adversity. Small firms go bankrupt much more frequently than large firms.

Product/Customer Concentration
An important factor in the stability of a company's future revenues and profits is the diversification of both its product portfolio and its customer base. Other things being equal, a company with a wide variety of products sold to a variety of end markets is less subject to economic or regulatory shocks than a more-specialized company.

Stewardship Grade
Our analysts assign each company we cover a Stewardship Grade of A through F. The Stewardship Grade captures our view of a company's transparency, board independence, incentives and ownership, and investor friendliness. We feel these are key components in determining whether a company's management team is looking out for investors (whether equity or bond holders) as opposed to their own interests.

Dependence on Capital Markets
We score companies based on whether their business models require them to regularly access the capital markets. For example, a firm that must securitize assets in order to fund its operations is vulnerable to significant problems when capital markets freeze up.

Cyclicality of Operations
The greater the economic sensitivity of a firm, the more likely it is to encounter financial difficulties. We pay special attention to the sensitivity of profits to economic cycles, penalizing firms with high fixed costs that crush profitability when revenues fall.

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Haywood Kelly, CFA has a position in the following securities mentioned above: MSFT JNJ Find out about Morningstar's editorial policies.
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