Long time readers of these pages know that I am an advocate of modelers to think long and hard about the assumptions behind their models before turning them on. Unfortunately, many are thimking instead of thinking.
Here is another example.
Using Altman Z for financials?
I recently participated in an online discussion in response to a financial modeler’s question about applying Altman Z to financial companies. (See my previous discussion on the limitations of Altman Z here.)
If you don’t know the Altman Z, the formula is a function of liquidity, balance sheet strength and earnings power:
Altman Z =
1.2 X Working capital/Total assets +
1.4 X Retained earnings/Total assets +
3.3 X EBIT/Total assets +
0.6 X Market value of equity/Book value of debt +
0.999 X Sales/Total assets
The formulation was originally conceived for operating industrials, not financials. It appeared to me that for someone to even ask the question about applying Altman Z to financials indicates that he hasn’t sufficiently thought about the assumptions behind the model.
You could plug it the numbers, it would give you an answer. GIGO: Garbage In, Garbage Out. It would be as useful as newly minted MBAs trying to apply Black Scholes to fixed income instruments.
The Financial Modeler’s Manifesto
Over at his blog, Paul Wilmott posted the Financial Modeler’s Manifesto, which starts with an echo of the Communist Manifesto:
A spectre is haunting Markets – the spectre of illiquidity, frozen credit, and the failure of financial models.
It concludes with “Modelers' Hippocratic Oath”:
~ I will remember that I didn't make the world, and it doesn't satisfy my equations.
~ Though I will use models boldly to estimate value, I will not be overly impressed by mathematics.
~ I will never sacrifice reality for elegance without explaining why I have done so.
~ Nor will I give the people who use my model false comfort about its accuracy. Instead, I will make explicit its assumptions and oversights.
~ I understand that my work may have enormous effects on society and the economy, many of them beyond my comprehension.
I wholeheartedly agree. Read the whole thing. Examine the assumptions in your models and apply them intelligently. If you haven’t seen Wilmott’s Newsweek profile, it’s also well worth a visit too.