Given the ongoing panic in coal shares, I decided to do a series which will look at several coal stocks using the Altman Z-score. The purpose will be to get a feel for the relative risk of each coal stock. This article will be on Peabody Energy (BTU). The Altman Z-score, as defined by Wikipedia, is:
The Z-score formula for predicting bankruptcy was published in 1968 by Edward I. Altman, who was, at the time, an Assistant Professor of Finance at New York University. The formula may be used to predict the probability that a firm will go into bankruptcy within two years. Z-scores are used to predict corporate defaults and an easy-to-calculate control measure for the financial distress status of companies in academic studies. The Z-score uses multiple corporate income and balance sheet values to measure the financial health of a company.
The Z-score is a linear combination of four or five common business ratios, weighted by coefficients. The coefficients were estimated by identifying a set of firms which had declared bankruptcy and then collecting a matched sample of firms which had survived, with matching by industry and approximate size (assets).
The Z-score has 5 inputs:
T1 = Working Capital / Total Assets.
T2 = Retained Earnings / Total Assets.
T3 = Earnings Before Interest and Taxes / Total Assets.
T4 = Market Value of Equity / Book Value of Total Liabilities.
T5 = Sales / Total Assets.
Which then come together using the following formula:
Z = 1.2T1 + 1.4T2 + 3.3T3 + 0.6T4 + .999T5
Calculation for Peabody Energy
The following data, obtained from Peabody Energy's latest 10-Q, is necessary to make the Z-score calculation:
Current assets: $3030 million.
Current liabilities: $1632 million.
Total assets: $16937 million.
Retained earnings: $3894 million.
EBIT (NYSE:TTM): $1676 million.
Total liabilities: $11124 million.
Market capitalization: $6440 million.
Revenues: $8270 million.
Using this data we get the following parcels:
1.2 * T1 = 0.099
1.4 * T2 = 0.322
3.3 * T3 = 0.327
0.6 * T4 = 0.347
0.999 * T5 = 0.488
This gives us an Altman Z-score of 1.58.
The Altman Z-scores are interpreted according to the following ranges (source: Creditworthy.com):
3.0 or more,
Most likely safe based on the financial data. Of course, mismanagement, fraud, economic downturns, and other factors may cause an unexpected reversal.
2.7 to 3.0,
Probably safe to predict survival, but this is a portion of the gray area and is below the threshold of relative safety.
1.8 to 2.7
Likely to be bankrupt within two years. This is the lower portion of the gray area and dramatic action may be required to effect survival.
Highly likely headed for bankruptcy. Rarely would a firm be expected to recover from a financial condition generating this or lower scores.
Quite incredibly, even Peabody Energy falls in the zone of high insolvency risk. It does manage to get a higher score than either Arch Coal (ACI) or Alpha Natural Resources (ANR), but it still isn't enough to clear the traditional Z-score "danger" zone. Again, this is probably due to:
- A very unfavorable point in the coal cycle;
- These companies being very capital intensive;
- The Altman Z-score not giving any weight to the coal companies' ability to generate a large cash flow, from the fact that depreciation and depletion of the coal reserves is a large non-cash cost that these companies have.
Yet, looking at Peabody Energy's partials, the much lower risk is evident. It carries a significantly higher EBIT, has large retained earnings, and all in all, it doesn't look like a bankruptcy candidate by any measure.
Next I will try calculating Patriot Coal's (PCX) Z-score. What I believe will come out of this exercise, is that the Z-score will be a good relative risk indicator, even if it does seem to overstate the overall bankruptcy risk in the coal firms.
Disclosure: I am long ACI, ANR, BTU.