How does asset quality affect stock prices?

The term “asset quality” has often been associated with the loan quality of banking institutions.

Banks use asset quality indicators to measure the overall financial risks of their loan portfolio, and predict how much provision they need to make to cover for potential losses from nonperforming assets.

In 1982, a professor from City University of New York by the name of Joel Siegel suggested in his book, “How to analyze businesses and financial statements,” that nonfinancial companies could also measure their asset quality to evaluate their solvency risks.

Siegel said nonfinancial companies could categorize their assets based on how easy it would be to convert them into cash.

For example, the intangible asset of a company can be considered a high-risk asset because it is harder to liquidate a goodwill asset than property or equipment.

Companies that defer certain expenses such as advertising expenditures, interest costs or brand trademarks and report them as asset in their balance sheet should also consider these items as high risk.

Siegel explained that companies with relatively high asset realization risk had also poor earnings quality because of the possible charge-offs that could happen in the future.

Siegel proposed that one way to measure the asset quality of a company, its asset realization risk, was to calculate the ratio of the noncurrent assets, excluding the property, plant and equipment, to total assets.

The greater the portion of a company’s assets in high-risk category, the higher the possibility that it will not be liquidated at fair value.

For example, the ratio of current assets and property, plant and equipment of Metro Pacific Investments in 2020 was 24.2 percent. If we want to evaluate its asset quality, we can simply deduct the 24.2 percent from 100 percent of total assets to derive its noncurrent asset ratio of 75.7 percent.

This high ratio indicates the asset-realization risk of Metro Pacific, which can be traced to its capital-intensive infrastructure investments.

Siegel said that because asset quality of a business could be affected by changes in economic conditions, a change in realization risks could also signal a change in profits and cash flows.

Back to our example, if we calculate the asset quality of Metro Pacific for the first half of this year, we will find that its noncurrent assets ratio has increased to 84.6 percent. This translates to an Asset Quality Index (AQI) of 1.12, which is derived by dividing this year’s 84.6 percent by last year’s ratio.

By rule of thumb, an AQI greater than 1.0 means that the company has potentially increased its deferred costs in its balance sheet, and therefore has lower earnings quality.

If we apply this concept by looking at the historical performance of the Philippine Stock Exchange (PSE) Index stocks for the past seven years since 2013, we will find that the average AQI of the market was negatively correlated with market returns.

For example, when Robinsons Retail’s AQI increased to 1.68 in 2015, its stock price fell by 16.8 percent compared to the previous year, but in 2016, when the company corrected its AQI to 0.95, its stock price immediately recovered by 17.9 percent by year-end.

This increase in stock price continued in 2017 with 29.6 percent as Robinsons’ Retail kept its AQI low at 0.95, but when its AQI began to pick up again to 1.08 in 2018, its stock price declined again by 16.8 percent at end of the year.

This year, Robinsons Retail’s AQI for the first half is slightly up to 1.02 from 2020, and its stock price is also marginally down by 3 percent year-to-date.

Applying this concept to our earlier example, Metro Pacific, which has higher AQI at 1.12 this year, we will find that its stock price is also down by 11 percent from its last closing price in 2020.

Asset quality is an important determinant of risk that can affect the value of a stock. The use of AQI is one tool that we can use to evaluate the asset realization risk of a company.

A lower asset realization risk as indicated by lower AQI leads to better earnings quality, which in turn increases the prospective valuation of a stock. INQHenry Ong is a registered financial planner of RFP Philippines. Stock data and tools provided by First Metro Securities. To learn more about investment planning, attend the 93rd batch of RFP program this January 2022. To register, email [email protected] or text at 0917-6248110