How can I benefit from credit upgrade?

Q: The stock market went up last week because of the credit rating upgrade by S&P for the Philippines. I am curious about how this credit rating will exactly affect our economy and the stock market in general. Can you explain?—Marjeline Lao by e-mail

A: For many years, the Philippines has always been rated low with speculative grade by international rating agencies. The uncertainties in the economy brought about by our turbulent political situation then made the Philippines highly risky in the eyes of foreign investors. Because of this, investors have always put a high risk premium whenever they invest in the country.

This risk premium comes in the form of high borrowing costs. The high-risk premium would also make the valuation of Philippine stocks unattractive that discourage many foreign investors.

Last year, for the first time in history, the Philippines crossed over into investment grade category. This change signifies that the country has shown promise of improving creditworthiness because of the fiscal reforms undertaken by our government. Last week, the Philippines got an investment upgrade from S&P with BBB rating, which reflects the growing confidence of foreign investors in the Philippines.

Publicly listed companies can also use this higher investment grade status to raise funds abroad with lower interest costs to finance their expansion. The investment upgrade will also mean stronger peso.

As investor, you would want your investment to create value for you by earning more income than what you expect. This expectation is your minimum rate of return on your investment in stocks. This is the lowest rate that will make you switch from investing in low-yield, risk-free securities to high-yield, high-risk equities in the stock market.

Let’s assume that you are invested in government bond that gives you annual yield of 4 percent. Although you don’t earn much from this, you feel that your money is fully secured because there is almost zero chance that the government will default. But you now want to invest in the stock market. For you to compensate the additional risk for higher returns, you put a premium of 6 percent so that your total required rate of return is 10 percent.

Now, let’s apply this concept to valuation. You will need to estimate the cash flow that you expect to earn from it and divide this by the difference between your required rate of return and the projected earnings growth rate of the stock. Let’s say you are valuing the stock of PLDT. This stock has expected cash dividend this year of Php181 and it is projecting earnings growth rate of 3.4 percent.

In order to value this, simply divide the cash dividends of P181 by the difference between your required rate of return of 10 percent and the projected growth rate of 3.4 percent, which is 6.6 percent. What you get is an estimated fair price of P2,742. The announcement of credit rating upgrade brought in a lot of foreign funds last week, which pushed the share price of PLDT to P2,974. This upgrade means higher confidence in the economy, which translates to lower-risk premium. Could it be possible that foreign investors have lower required rate of return?

Let’s find out what they must be thinking. Assume that you are willing to lower your risk premium by 1 percent so that your total required rate of return is now at 9 percent. Repeat the valuation process by dividing the expected cash dividends of P181 by the difference between your new required rate of return of 9 percent and expected growth rate of 3.4 percent, which is 5.6 percent. What you get is a higher target price of PLDT at P3,232.

Take advantage of the credit rating upgrade fever while it lasts. Increased confidence means higher stock price valuation and bigger trading opportunities. Remember to use proper diversification as different stocks have different risk profiles.

enry Ong is a registered financial planner of RFP Philippines. To learn more about investment planning, attend the Registered Financial Planner (RFP®) program on May 24 to July 12. To inquire, email [email protected] or visit www.rfp.ph for details.