I was looking at conditions in the shipping industry today, and I thought back on a stock that I used to own — Tsakos Energy Navigation Limited [TNP]. I think I sold it in 2007 or so. I was shocked to see it selling for a tiny fraction of the price of where I sold it. And so I thought: Is it going to go broke?
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I turned to my favorite measure of credit risk to try to answer this: (Long-term Debt + Short-term Debt) / Market Capitalization. Unless a company is in a very stable industry, I like that figure to be under one. For TNP, it is not a stable industry; it is in a highly cyclical business. The current value of that statistic is 11.
What’s the logic here? Debt claims are fixed as far as the debtor is concerned. For TNP, all of the debts are secured by their ships. But the best estimate of what the residual claimants (stockholders) have for the value of their holdings is market capitalization. Thus the ratio of debts to market value of equity can be a simple summary of how levered the company truly is. In this case, TNP sells at around 0.1x of its book value. Is it cheap? Yes, and particularly on a Price-to-sales basis. Is it safe? No. Will I buy some? No. Will I short it? I never short. Is it going broke? Who can tell? It doesn’t have a sufficient margin of safety for me.
If I were one of the banks lending against the TNP ships, I would look at different metrics — Value of the ship as a ratio of the loan, marginal earnings of the ship as a ratio of financing costs, etc. But if TNP decided to not pay on any ship loan in hard times, it would negatively affect their ability to finance new ships, and refinance existing ships. Not paying would be catastrophic.
The intuitive way to think about this ratio is like this: the value of a stock is the present value of the future free cash flows. The value of the debt is the present value of the future debt payments. So the higher the ratio goes, the thinner the margin is for making the debt payments. Also, equity has the optionality of “Heads I win, Tails you lose” to creditors. The most the creditors can do is get paid back, but they can lose it all (in this situation for TNP, the downside is capped by the collateral). But though the equity can lose it all, in the right situation they can multiply the value highly if the cycle turns favorably.
Anyway, I think this is the best quick take on credit risk as far as stockholders are concerned. If others have better ideas, please share them in the comments.
Article by David Merkel, The Aleph Blog
