CDS Factors In Equity Valuation - Part A

As indicated in the previous post, I have started work on a share valuation model that attempts to integrate Credit Default Swap factors into the equation. This will be done as a series of postings, not only because it would otherwise result into one very long post, but also to allow for timely and helpful comments from readers, as I go along.

Professional colleagues already know that the CDS market has a very big impact on stock prices. There are plenty of models on this correlation, particularly amongst the quant and prop traders. If any of you chance upon this blog it may feel like ...coals to Newcastle. But as will become clear, particularly in later instalments, my idea is not to price stocks based on CDS or vice versa, but to look at the possibility that stocks appear relatively undervalued because a part of the equity risk has been stripped out and is trading separately OTC in the CDS market. It's a bit like creating zero coupon bonds from regular bonds by "clipping" the coupons. Likewise, the stock "corpus" trades on the regular exchange, while its risk "coupon" trades OTC as CDS. To get the proper price we must put both together. I have not personally seen this idea floated anywhere, so if anyone has, please let me know.

A note for those who shudder at mathematical equations: All that will be involved are the four basics: +/-* . Perhaps a Δ (change) and a Σ (sum) here and there but no calculus, I promise. At least not in the first installment... ;)

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Part A: The Basics of Equity Valuation

In standard portfolio theory, equity prices can be calculated as the sum of (a) the present value of the series of expected dividends plus (b) the present value of the annual "extra" we expect to receive in the form of capital appreciation and dividend growth, commonly called the Risk Premium.

Price = Discounted Cash Flow + Risk Premium

=> P = DCF + RP (Equation 1)

The DCF calculation is pretty straightforward: take the series of annual dividends for 30 years, apply a discount interest rate (usually the 30 year Treasury) and arrive at the present value. There may be slight variations depending on the number of years used (30, 40, 50?) and the discount rate, but on the whole that part of the valuation is not volatile, simply because dividends don't change very fast.

When expressed as an interest rate (the usual way) Risk Premium has an inverse relationship to equity pricing: the lower the risk premium, the higher the resulting stock price. The "classical" way to estimate RP as an interest rate (RPi) is through the P/E ratio (PE):

RPi = (Earnings/Price) - (Real 30 year Treasury yield)

=> RPi = (1/PE) - Real Yield (Equation 2)

A way to arrive at the P/E ratio and thus current equity pricing, is to solve the above equation for PE:

=> PE = 1/(RPi + Real Yield) (Equation 3)

This clearly requires that we independently provide the value for RPi, the Risk Premium rate. Keep this firmly in mind as we progress, because it is the window through which the CDS market enters into equity valuation.

We may think of RPi as the "extra" spread above and beyond current dividend return that an investor is willing to accept in order to assume the risk of holding stocks, instead of risk-free assets (e.g. Treasury bonds). This is partly what Alan Greenspan was referring to when he warned, right before he left the Fed, that prolonged periods of unusually low risk premia commonly end up badly*. Simply put, they indicate a high degree of risk appetite, i.e. speculation.

To put this into perspective, at the recent S&P 500 top of 1555 the present value of dividends (i.e. DCF) came to approx. 400 points, with the rest accounted for by the Risk Premium. Therefore, share buyers at that point were expecting 75% of their returns to come from capital gains and future dividend growth. Today's situation is not much different, with 425 S&P points accounted for by DCF and 1020 points by the Risk Premium, i.e. the split is now 71% - 29%. These are very high imbedded expectations for growth, particularly when one takes into account that corporate earnings as a percentage of GDP are currently at an all time high.

The question thus arises: why are investors willing to accept such low risk premia (when expressed as interest rates)? Has anything changed in the way we calculate or estimate RPi in equation (3) above, to arrive at higher P/Es? The answer is certainly yes and the reason can be found in the explosive growth of the Credit Default Swap (CDS) market, which is functioning as a mechanism for stripping out and trading separately that portion of risk associated with creditworthiness. Naturally, creditworthiness is highly correlated to corporate finances and we can readily perceive how signals from the CDS market quickly find their way to share prices.

That will be the subject of Part B, which I will post in the next few days.

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(*) Unlike many in the financial blogosphere, I have great respect for Mr. Greenspan. We can certainly argue bubble creation, but under the circumstances he was probably the best Fed Chairman ever. I point out that he warned against the dotcom madness and even raised rates to contain it, despite then low inflation. The drastic rate cuts he engineered must be viewed through the events of 9/11 and were completely justified, at least up to a point. Don't forget he also had to deal with a mad-hatter fiscal policy designed by the Bush II neo-conservative administration. I also appreciated the merciless way in which he tortured English language syntax when providing congressional testimony. He could speak for hours without anyone understanding a damn thing - he was proud of it, too!