Given the increased likelihood that appraisers will be engaged to assess distressed companies, Morningstar’s valuation research team recently reexamined two common bankruptcy prediction models—the Z Score and Distance to Default (D2D) models. Duff & Phelps currently uses the Z-Score to rank high financial risk companies in its High Financial Risk Portfolio Supplement
, and Morningstar uses the D2D model to calculate a daily “Financial Health Grade” for all public companies in its equities database at Morningstar.com
: “Distance to Default outperformed the Z-Score in both ordinal and cardinal bankruptcy prediction,” writes Morningstar’s James Harrington (Director of BV Research) and Warren Miller (Senior Quantitative Equity Analyst), in the next (October 2009) BVUpdate
. “Curiously, the Z-Score’s predictive ability is nearly equal to the other model when ranking relatively safe companies but performs worse in situations when the bankruptcy probability is high. Compared to the other model, D2D also had a higher average rating just prior to bankruptcy and a lower bankruptcy rate for companies it had categorized as ‘safe’.”
As a result, Morningstar has developed a new D2D model that “better assesses a company’s health and leads to more accurate public and private company valuations.” The BVUpdate
article is based on Miller’s original whitepaper, “Comparing Models of Corporate Bankruptcy Prediction: Distance to Default vs. Z-Score,” now available as a free download from Morningstar
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