Synthetic credit rating

Most European companies you will be asked to value have no traded bond. They borrow from a relationship bank, from a direct lending fund or through a private placement, and none of that debt is quoted. The synthetic credit rating method builds a cost of debt for them out of published relationships rather than an observed price.

It runs in four steps. Compute an interest cover ratio, usually EBIT divided by interest expense. Map it to a rating band using a published coverage to rating table, adjusted for size, because a small company needs more cover than a large one to earn the same letter, its earnings being more volatile. Take the spread that band currently carries in the market and in the currency you are working in. Add it to the matching risk free rate for a pre tax cost of debt, then apply the tax rate for the after tax figure the WACC uses.

Its weakness is the step that looks most solid. A rating was never a function of one ratio. Agencies weigh scale, diversification of customers and geographies, the volatility of cash flow rather than its level, the maturity profile, the sector and country, and whether an owner would stand behind the company. A business with comfortable cover and a single customer is flattered by the table, so treat the output as a band rather than a rate.

There is also a circularity worth naming before an interviewer names it for you. Interest expense depends on the rate, the rate depends on the rating, and the rating depends on a ratio built from interest expense. A model resolves that by iteration. In conversation, say you would run the ratio on a normalised interest charge at the target capital structure rather than on the charge the company happens to carry today, which is the same discipline that governs the WACC weights.