One of the hallmarks of the Duff & Phelps Risk Premium Report is its exclusion of highly leveraged, financially distressed companies from its baseline data, placing them into a separate “high financial risk” portfolio.  When a subscriber recently asked how (by what criteria) this separate category is created, Roger Grabowski provided the following overview:

“For each year since 1963, we filtered the universe of companies to exclude the following: 

• Companies lacking 5 years of publicly traded price history;
• Companies with sales below $1 million in any of the previous 5 fiscal years; and
• Companies with a negative 5-year-average EBITDA (earnings before interest, taxes, depreciation and amortization) for the previous 5 fiscal years.

“Companies that pass this test have been traded for several years; have been selling at least a minimal quantity of product; and have been able to achieve some degree of positive cash flow from operations.  This screening responds to the argument that the ‘small cap’ universe may consist of a disproportionate number of high-tech companies, start-up companies, and recent Initial Public Offerings; and that these unseasoned companies may be inherently riskier than companies with a track record of viable performance.  The number of companies eliminated by these criteria varies from year-to-year over the sample period.  Once we eliminated these companies, we created a separate portfolio for those with any one of the following characteristics:

• Companies identified by Compustat® as in bankruptcy or in liquidation;
• Companies with 5-year-average net income available to common equity for the previous 5 years less than zero (either in absolute terms or as a percentage of the book value of common equity);
• Companies with 5-year-average operating income for the previous 5 years (defined as sales minus (cost of goods sold plus selling, general and administrative expenses plus depreciation)) less than zero (either in absolute terms or as a percentage of net sales);
• Companies with negative book value of equity at any of the previous 5 fiscal year-ends; and
• Companies with debt-to-total capital of more than 80% (with debt measured in book value terms and total capital measured as book value of debt plus market value of equity).

“We excluded these companies from our base set and placed them in a separate ‘high financial risk’ portfolio, thereby seeking to isolate the effects of high financial risk.  Otherwise, the results might be biased for smaller companies to the extent that highly leveraged and financially distressed companies tend to have both high returns and low market values.  It is possible to imagine financially distressed (or high risk) companies that lack any of the above characteristics.  It is also easy to imagine companies which have one of these characteristics but which would not be considered financially distressed.  Nevertheless, we are confident that the resulting ‘high financial risk’ portfolio is composed largely of companies whose financial condition is significantly inferior to the average, financially ‘healthy’ public company.

“The number of companies classified as ‘high financial risk’ varied over the sample period,” Grabowski concludes.  “These companies represented approximately 25+% of the data set in recent years, but less than 5% in 1963.  Certain technical changes in methodology have resulted in a greater number of companies falling into the ‘high financial risk’ portfolio than in versions of this study published prior to 2000.”  To order the 2008 Risk Premium Report, click here.