Value for valuation

The importance of determining the value of liabilities is increasing

Value for valuation

When the financial world talks about market value, it usually concerns the asset side of the balance sheet. Asset managers are constantly determining the value of shares and bonds.

In turn, banks specialize in determining the value of loans and mortgages. But the market valuation of liabilities continues to receive little attention. This is about to change, however, because of the growing importance of accurately determining the current and future values of companies (which is, after all, the difference between their assets and their liabilities).

Why is the market value of a company (and thus its liabilities) interesting?

The market value of a company’s liabilities and its entire balance sheet is relevant to financial and management reporting. Basing reporting on market value not only gives stakeholders insight into the company’s correct economic value (represented by the market value of stockholders’ equity), but also into the correct economic value changes (represented by the profit and loss account, or the result). This gives an incentive to manage the company according to real economic principles.

Secondly, a company’s market value is relevant from a risk perspective. One of the most frequently used methods in managing risks at banks is thinking in terms of economic capital. Potentially extreme losses (value changes) are set against the ability to absorb the losses (market value of stockholders’ equity). Controlling risks should also be based on real economic principles.

“Including credit spreads in reporting has a moderating effect on the presented results of a company.”

How do you determine the correct value of liabilities?

When valuing assets there is often a correction for expected losses. A loan of EUR 100, for example, will pay a certain credit spread on top of the risk-free interest rate to compensate for the eventuality that the loan will not be repaid. A frequently used valuation method is to discount the cash flows of the loan with the interest including the same credit spread. This results the value of the loan to equal the EUR 100.

Similarly, when determining the value of the liabilities, the cash flows are usually discounted with interest. But should a spread be added on top of the risk-free interest rate? And, if so, which spread? If we follow the method described above, it would be the spread of the company that issued the loan, or its own credit spread!

This article argues in favor of using a company’s own credit spreads when determining the value of liabilities. The most important reason for doing this is consistency in value perception between the two parties that enter into the asset/ liability relationship. In the case of a simple loan, for example, the value of the loan will, in the perception of the issuer, be corrected for expected losses. At this value the owner should be indifferent between holding the loan and obtaining cash.

In other words, in a rational world, the party who borrowed the money would be able to redeem his loan for an amount equal to the value perceived by the issuer. By including your own credit spread in the valuation of the liabilities, an estimate of the cash amount is obtained needed to redeem the liability or, in other words, an estimate of its actual value.

Isn’t including credit spread counter-intuitive? It may appear counter-intuitive to factor in your own credit spread when determining liabilities. After all, there seems to be no uncertainty about a company having to pay its liabilities. Yet this is not the case. For if a company goes bankrupt, it will no longer be able to meet its liabilities. And that is precisely why you pay a credit spread on top of the risk-free interest rate.

“The size of potential future losses will be limited by managing according to a stable development of the value of the company under all market conditions.”

A second seemingly counter-intuitive consequence is that the value of a company increases if its credit spread rises and vice versa. After all, a higher credit spread means discounting with a higher credit spread, which results in a lower value of the liabilities.

So if assets remain the same, the value of the company will increase. That does not seem logical because a credit spread increase of a company indicates that the market actually has a lower estimate of its creditworthiness! This situation is not realistic, however. A lower opinion of creditworthiness is usually the result of a lower value of the assets.

Consequently, the decrease in the value of liabilities is a consequence (possibly a delayed one) of the decrease in the value of the assets. Below the line the value of the company will thus not increase as a result of a declining creditworthiness.

What are the consequences of including credit spreads?

Firstly, including credit spreads has a smoothing effect on the results of a company. If things go well, the value of its assets increases. However, the value of the liabilities will also increase, because the credit spread decreases.

So the increase in the value of the assets will not directly effect profit, it will be reduced by the increase in the value of the liabilities as well. If things go badly, the opposite will happen, which means that the loss will be moderated.

Secondly, including credit spreads can influence risk management in two ways:

  • the estimate of current solvency (measured according to the value of the company, or in other words the buffer for potential future losses);
  • the control of potential future losses (measured according to the value changes of the company).

Credit spreads in the valuation of insurance liabilities

Theoretically, the value of a life insurance liability is equal to the value that the policyholder assigns to it. In reality, however, the value perception of policyholders depends little on the (theoretical) credit spread of the insurer. Moreover, the possibility for redemption is very limited.

So in the case of insurers the inclusion of credit spreads does not produce a better insight into the value or the changes in value of the company.

The consequence of including credit spreads on top of the risk-free interest rate is that the value of the liabilities will be lower than the value without credit spreads. As a result, solvency will be estimated higher, so more solvency will be visible to absorb future losses.

The size of potential future losses will be limited when managing according to a stable development of the value of the company under all market conditions. This is achievable by aligning the value development of assets with the value development of liabilities, called asset and liability management (ALM).

Regarding interest rate risk, for example, the interest rate durations between assets and liabilities can be aligned to decrease the influence of interest rate fluctuations.

In many cases a relation may be expected to exist between a company’s own credit spread and the credit spreads in the assets. The influence of spread movements on the company’s results can be reduced by aligning the contractual durations* (spread durations) between liabilities and assets. A similar spread movement between the company’s own credit spread and the credit spreads in the assets will then result in equal value changes in debts and assets.

The result, which is after all the difference between these two, will then become more stable, thus reducing potential losses and its claim on solvency.

* An example of deviations between contractual durations and interest durations is a loan with a variable interest rate. Covering the interest rate risk by means of interest rate swaps can also cause differences between the two types of durations.