Equity Research Report

Equity Research Report
Overview
For the equity research report, you will put yourself in the shoes of a stock analyst to study,
examine, and value your chosen company before making a buy or sell recommendation based on
the current stock price.
An equity research report is generally prepared by equity analysts in investment banking houses
to provide information to investing clients, advisors, and other interested parties about the stock’s
future potential and to recommend a purchase or sale of the stock.
The analyst would recommend buying a stock if he estimates the value of a share to be greater
than the price which you can buy it on the market. Similarly, he would make a sell recommendation
if he values the company below its current market price. There is some evidence that analyst
reports are positively biased, because of lack of incentives to produce negative reports. Of course,
you can prepare your own unbiased report and use it for your own internal consumption at the time
of investing. The idea is to find good bargains and avoid buying overvalued stocks. This is tough
because securities usually trade at their fair price if markets are fairly informationally efficient.
There are several different valuation techniques. The valuation principle you will use for to
estimate the firm’s value is known as the discounted cash flow method, or “fundamental
valuation.” You will do this by first forecasting the expected future cash flows and then discounting
those cash flows back to present value. The discount rate is based on the riskiness of the forecasted
free cash flows. After these cash flows are discounted back to present value, you adjust the
estimated firm value for debt and preferred stock outstanding, and divide by the shares outstanding
for your target stock price.
The report will contain the following sections:
Executive Summary Analyst Name and Company, Firm being analyzed: Name and
Ticker Symbol, Price on report date, Forecast horizon,
Recommendation (Buy, hold or sell; or strong buy etc.), Target
forecasted price, Highlights, Summary of analysis
Qualitative Analysis Company profile or business description, Industry overview, SWOT
analysis, Management, Major owners, News, Summary of technical
analysis and charts
Financial Statements
Analysis
Ratio Analysis and Interpretation, Earnings Forecast, Growth
forecast, Trends over time and versus competitors
Risk and Pricing Risk factors, Computation of Required return or discount rate,
Calculate Fair Price, Compare with market, Recommendation
Appendix: Actual financial statements
The report usually contains an executive summary page with the key recommendation. This
recommendation should be based on very solid justification. Next, the report details the qualitative
analysis of the firm’s business and the industry conditions. Following this, is a financial statement
analysis section which numerically forecasts earnings and future dividends. Finally, you assess the
risk factors to compute the appropriate rate at which to discount future cash flows to arrive at the
fair price that should be paid for the stock. Any factual information and the actual financial
statements should be included in the appendix. The report itself should contain the interpretation
of these facts.
Where to start
There are many potential sources of data and information about the company which you will need
to gather and review when you are preparing the report. Every listed firm is legally required to file
its statements at the publicly-accessible SEC (Securities and Exchange Commission) EDGAR
website. They will also have information on the company’s own investor relations webpage.
Bloomberg, Reuters, and the Wall Street Journal are good, albeit expensive, media and data
sources for latest news about the company. A nice free website which is an excellent source of
qualitative and quantitative financial information is Yahoo Finance. Gather all of your hard data
and source material (financials, economic outlooks, competitors’ financials, etc.) and be sure to
include them – formatted neatly – into your report’s appendix.
Qualitative Analysis
It is important to analyze each piece of information in your report. Don’t just copy it into the report;
you must interpret it. What is the meaning of each piece of information and how it will effect
stock’s fair value, in your opinion?
Your analysis will begin by using qualitative factors and analysis to determine the business
outlook. In other words, how will fundamental information affect future cash flows in the
numerator of the valuation equation?
Think about how every piece of information will affect future sales or revenues (i.e. the top line
of the income statement). Will the sales increase due to economic recovery and growth OR will
the sales decline due to competition and other factors?
Also think about how this information will affect the bottom line (i.e. EPS, free cash flows, or
dividends). Will the costs rise due to inflation, or will the firm successfully control costs and
increase profitability?
Keep in mind that sales often have patterns such as seasonality, trends, business cycles, growth
through innovation. So when you are projecting the future sales all these trends and patterns should
be helpful in making a more accurate forecast.
First, try to forecast how the overall economy will perform in the forecasting period. If the
economy grows most firms are likely to share the fruits of that growth. If the economy will be in
recession than most firms will experience declining sales. There are some exceptions such as
Walmart or inferior good manufacturers, which may do well in recession. Take this into account
when you are analyzing the GDP growth rate, which is usually forecasted by economists and
should help you to predict the firm’s growth.
Now determine the stage of the industry’s life cycle. Industries in the pioneering stage may have
losses in their initial years – Amazon had huge losses in the initial years after the website was
launched – but then these firms can earn high profit margins as the product is established.
To determine how qualitative factors will affect your firm’s top and bottom lines, you’ll need to
use your own opinions, research and creativity. This may include relevant news articles, technical
analysis/charting, a SWOT (Strengths, Weaknesses, Opportunities, Threats) matrix, and knowing
the major shareholders and managers of the firm. The possibilities are endless, but for your report,
you’ll ultimately need to forecast revenues and expenses, so you’ll need to justify them with your
analysis.
To analyze management and ownership of the firm you need to ask yourself:
Who is running the firm that you are analyzing? What is their background, skill set, and
experience? How are they paid? Cash compensation may leave managers unmotivated, options
may lead managers to take on too much risk, bonus compensation may lead to earnings
manipulation. Therefore, the best practice firms tend to use cash plus restricted stock unit
compensation for their managers. Most importantly, try to examine management’s track record of
allocating capital. i.e. how does management makes use of profits once they have been earned?
This is important because poor allocation of your profits can destroy great business, regardless of
how much profit you make. If you making dumb investments with that profit, it won’t help you
much in the long‐run.
Quantitative Analysis
Financial Statement Analysis is done to assess the financial health of a firm. Within this section,
you will compute and interpret various types of ratios, and highlight any changes in these ratios
over time and any major differences in ratios across the firm and its competitors.
The next goal is to project the firm’s EPS in the next year. The best places to start are curr ent and
historic financial statements, (We already have this data!) and use your qualitative and ratio
analysis to determine why revenue, expenses, earnings and cash flows are moving up and down
each year.
For projecting future expenses, it is useful to common size the historic and current statements as
% of sales and then use the ratios for forecasting next year’s expenses, being sure to factor in our
qualitative analysis. Now to get the earnings per share we divide the net income by the number of
shares outstanding. A short cut to find the number of shares outstanding is to divide the Market
capitalization by price. But be mindful that firms can add more shares in future through equity
offerings, and (more commonly) the exercise of stock options by its executives. If so, then you
should increase the number of shares outstanding for the future.
Historic Data Common Size Average & Adjust Forecast
2009 2008 2009 2008 2010
Sales or
Revenues
$14.6
Billion
13.5 8%
growth
9.9%
Growth
8.95% adjust down to
6.5%; recession
$15.5
Billion
Various
Expenses (% of
sale)
$12.5
Billion
11.3 86% of
sales
84% of
sales
85% adjust down to
83%; cost cutting
measures
$12.9
Billion
Net Income $2.1
Billion
$2.2
Billion
$2.6
Billion
EPS 1.94 1.97 2.32
Risk Analysis and Pricing
Next you’ll analyze the risk of the firm to estimate an appropriate discount rate. The discount rate
should increase as the firm’s cash flows gets riskier. Some people just use a “common sense” rate
of required return. Others rely on sophisticated mathematical modeling to determine the risk
premium (the additional return in order to compensate investors for uncertainty about the stock’s
future performance) on the stock. To do this, you will require the risk free rate plus a risk premium.
The proponents of the advanced mathematical models claim that only systematic risk (and not
idiosyncratic risk) is rewarded in the stock market. This type of risk is caused by macro factors
such as changes in interest rates, GDP growth, supply shocks, financial crisis. Therefore, to
measure systematic risk, we estimate the covariance of the stock returns with the market portfolio.
This covariance is called beta (β). Beta estimates a stock’s systematic risk. Unsystematic risk is
not rewarded because you can easily reduce or eliminate it by holding well diversified portfolios.
The Capital Asset Pricing Model provides a framework for computing the required return from the
stock. Essentially, discount rate that you will put into the dominator of the valuation equation
would be the required return according to the CAPM. This required return is:
𝐸(𝑅𝑖
) = 𝑅𝑓 + 𝛽𝑖
[𝐸(𝑅𝑚) − 𝑅𝑚]
Rf is the risk free rate, which can be estimated using the treasury bill rate. You can find this
information on US Treasury website. (http://www.ustreas.gov/offices/domestic‐finance/debt‐
management/interest‐ rate/yield.shtml) For example, the rate was 0.43% in September 2009.
You can obtain βi from Yahoo Finance or Bloomberg, or estimate it yourself by regressing 24-60
months of historic stock returns (Ri) on historic market returns (Rm).
A commonly used proxy for a forecast of market wide stock returns, Rm, is the historic S&P 500
index return. Historic average for large stocks according to many textbooks is between 10 and 12%
per year. You can then adjust this historical average to incorporate your opinion about the long
run future of the stock market.
Dividend Discount Model: Single Stage
Now that you’ve estimated future cash flows, growths rates, and the discount rate, you can now
estimate the value of the stock. This is the primary contribution of your equity report: the target
price of the stock. There are multiple methods and models used to arrive at an estimated target
price. We will cover several in this tutorial. You will need to use at least one appropriate discounted
cash flow method, but you may wish to try several different models to see how sensitive your
target price is to the assumptions implicit in each model. First, we’ll cover the single stage dividend
discount model, otherwise known as the Gordon Growth Model:
𝑃0 =
𝐷1
𝐸(𝑅𝑖

) − 𝑔

𝐷0
(1 + 𝑔)
𝐸(𝑅𝑖
) − 𝑔
Suppose you’re valuing an established firm in a mature industry with a steady growth rate. If we
assume that dividends will grow at a constant rate in perpetuity, and that the require return for
equity holders doesn’t change year-to-year, we can mathematically show that the fundamental
present value of the stock is equal to next year’s dividend (D1) divided by the required return
(E(Ri)) minus the growth rate (g). Since we don’t know for sure what D1 will be a year in advance,
we can use the most recent dividend (D0), and grow it by the growth rate (1+g).
Free Cash Flow Model: Single Stage
What if the firm you’re valuing doesn’t pay a regular dividend? What if the firm’s dividends are
too erratic to be valued by a smooth growth rate? What if you are valuing a closely-held firm and
dividends aren’t public knowledge? In any of these cases, the Gordon Growth Model won’t be the
best choice, and you may need to use a discounted free cash flow model instead.
𝑉𝐹 =
𝐹𝐶𝐹𝐹1
𝑊𝐴𝐶𝐶 − 𝑔
𝑜𝑟 𝑉𝐸 =
𝐹𝐶𝐹𝐸1
𝐸(𝑅𝑖
) − 𝑔
The models look very similar, but instead of dividends per share, you use the firm’s free cash flows
to find the overall value of the firm. BEWARE! We can use either Free Cash Flows to the Firm
(FCFF) or Free Cash Flows to Equity (FCFE), but we need to adjust our discount rate and outcome
variable accordingly. Notice that when we use FCFE, we discount by the required return of equity
holders (E(Ri)) and we calculate the value of equity (VE). This isn’t the price of each share, but the
overall value of equity, so you still need to divide this by the number of shares outstanding to
arrive at the target price per share. Now see that when we use FCFF, since we haven’t taken out
any interest payments or changes in debt, we need to discount by the weighted-average cost of
capital (WACC), and we end up calculating the value of the firm, not the value of equity. Once we
value the firm, we need to adjust this figure by subtracting off the value of debt, adding the value
of non-operational assets (investment property, stock in other companies, etc.), and then dividing
by the shares outstanding to arrive at the target price per share.
Multi-stage Discounted Cash Flow Models
What if you’re valuing a firm with a growth rate higher than the required return on equity? This
will give you a negative valuation in the single stage growth models (technically, we derived the
Gordon Growth Model using a Taylor-series expansion which assumes E(Ri) > g, so if this isn’t
the case, we get an infinite value, not negative). What if you’re valuing a firm in the early stages
of its industry, and the growth rate will be very high for a few years before coming back down to
a terminal growth rate (gt)? In either case, you’ll have to use a multi-stage growth model. The good
news is that the multi-stage models work with either dividends or free cash flows. You just need
to use the appropriate discount rate (k) depending on which cash flow (CF) you’re using – D,
FCFF, or FCFE.
𝑉0 =
𝐶𝐹1
(1 + 𝑘)
+
𝐶𝐹2
(1 + 𝑘)
2 + ⋯
𝐶𝐹𝑡 + 𝑉𝑡
(1 + 𝑘)
𝑡
, 𝑤ℎ𝑒𝑟𝑒 𝑉𝑡 =
𝐶𝐹𝑡+1
𝑘 − 𝑔𝑡
This model, especially when used with FCFF, gives you the most control and the flexibility to
value any firm, but it is also the most labor intensive and complex because you have to forecast
cash flows for t or (t+1) years. Remember, if you’re using free cash flows, you’ll still have to make
the appropriate adjustments to go from the value estimate to the target price per share.
Valuation based on Price Multiples
An alternative approach to this is to project a price multiple for the firm. We have already projected
earnings per share (EPS) in the financial statement analysis and now we are trying to find the fair
price, P0. So we can use EPS times the projected price to earnings multiple (P/E). In order to get
this forecasted price to earnings multiple, you can use various benchmarks such as historic,
industry-average, market-wide average. You don’t have to stop at the P/E ratio. Since earnings can
sometimes be negative, it’s not uncommon to use a Price/Sales multiple. Since earnings is
influenced by some arbitrary accounting principles, many finance people prefer price-to-cash flow
multiples. In the early 2000s, many “dot com” firms didn’t even have revenue, but they needed
money from investors. How were they valued? Venture capitalists used price-to-click multiples
for several of these firms. While your imagination may be the limit, the P/E multiple is probably
the safest. Since the terminal firm value (Vt) is hard to estimate so far into the future, some analysts
use multiples to estimate the terminal firm value. Multiple valuation can give you slightly different
estimates for the fair price of the stock. Depending on what method you use and your assumptions,
you might get different estimates of the fair price. At the end you can use plain average or weighted
average from the different approaches to forecast the stock price in the future.
Once you can have the fair price, you will then make your recommendation on the stock.
– Recommend a purchase if market price is significantly less than your target price
– Recommend selling if the market price is significantly higher than your target price
– You can recommend holding the stock if the market price is too close to your target price to
generate a decent return
It is good practice to calculate the potential return based on today’s price and your target price.
Finally, it is a very good idea to perform sensitivity analysis or scenario analysis. In short, vary
your assumptions about sales and/or costs to learn what might happen to the stock price under
optimistic or pessimistic scenarios for the stock. The stock’s price is going to be most sensitive to
your assumptions about required return and terminal growth rate, so it’s good to vary these and
see what ranges give you buy, sell, or hold recommendations.
Project Grading Breakdown:
Section Points
Executive Summary 10
Qualitative Analysis 30
Financial Statement Analysis 20
Risk and pricing 30
Overall Quality 10
Total 100

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