Equity valuation is a process of assigning a value to a firm’s stock. An equity research report is a form of communication which aims to share the results of equity valuation performed by an analyst. It provides valuable information about a company, recent updates and an estimate regarding the share price of the company (or the target price) at a future date usually one year from the date of writing the report. It also issues recommendations on whether to buy, hold, sell or avoid the security covered. A reader of such a report could be a current equity shareholder, prospective investor or any such entity who is interested in the future prospects of the subject company.
It is imperative that the readers should be aware of the table of contents of the report and the major points under every section to make the reading experience more productive. This article will guide you through these specific points to understand the supporting details of the analysis which forms the basis of the target price. If a report claims that there is a 12% upside case for a stock, can you as a reader verify the same by going through the investment thesis, by being able to identify the key catalysts and in the end be in a position to comment whether you agree or disagree with the issuer of the report.
There is no uniform industry standard for following a particular format and reports can vary in length and complexity. However, most of the sections in a report will have common elements. Highlighted below are the frequently used contents and the key points within them.
Key Company Data
On the first page of the report, there will be several data points regarding some basic information about the subject company. For example, company’s ticker symbol, current market price, target price, recommendation- buy, sell, hold or avoid, market capitalization, 52 week high/low, total number of shares, short business description, major shareholders, etc. Many analysts also include a quick snapshot of selected financials and ratios.
Investment summary
We can expect this section to be in the beginning, but regardless of its position, it remains one of the most important one. As the name suggests, it will summarize the overall analysis, cover the key investment positives & negatives and provides the rationale behind the bullish or bearish stance. In other words, the valuation professional or analyst will include an explanation as to why the security is undervalued or overvalued. Let’s dwell into these scenarios-
- Overvalued– A sell rating is issued if a security is overvalued. One situation could be that the company has been a strong performer in the recent past; however, the growth is likely to moderate now due to increased competition. For this reason, the current valuation is expensive and the analyst expects the stock to moderately correct going forward.
- Undervalued– Here, a buy rating will be issued. For instance, an analyst may be confident about the outlook of an FMCG company due to continued expansion both in home and abroad, better product mix, favorable macroeconomic environment, etc.
It has been observed that majority of the reports carry a buy rating, so make sure to be aware of what catalysts will prompt the market to re-price the security. Hence, knowledge of management’s decision to increase sales outlets alone is not sufficient. Try to find answers such as timeline of the opening of these outlets, can we quantify the increase in top line and bottom line numbers i.e. the revenues and earnings due to the increased asset base, etc.
Business Description, Management and Corporate governance
While the first page may have a short business description, expect a detailed description of the company in this section. It will discuss about the business model, history and nature of operations, products & services, key mergers & acquisitions, geographic coverage, key personnel, composition of board of directors and whether such a board can act independently, etc.
Industry Overview and competitive positioning
This section has two parts (a) Industry overview and (b) Competitive positioning
(a) Industry overview sub section will provide commentary on the description of the industry, geographic spread, total market size, details pertaining to major segments, key drivers, production capacity levels, etc. Try to assess how will the current trend and future outlook of the market impact the subject company. Specifically, an average firm is expected to mirror the growth trend projected for the sector. So, if an industry such as automobiles is expected to witness a 7.5% CAGR in the next 5 years, the reader should compare the company projections made by the analyst over the same period. If it is found that company growth rate is assumed to be 12%, look for reasons for deviation from the average growth rate.
(b) Competitive positioning sub section should convey where the firm stands in relation to its peer group. The “Porter’s Five Forces” framework for industry analysis is a popular tool to discuss how a company is able to differentiate its offering and carve out a spot in the competitive landscape. The five forces are- threat of potential entrants, bargaining power of buyers, bargaining power of suppliers, threat of substitute goods/ services and intensity of industry rivalry. Additionally, this section will highlight a few significant competitors, their recent financial performance, key strategies, etc.
To illustrate, in one of the analysis, Maruti Suzuki India Ltd. was found to experience the effects of five forces at varying intensities. A strong (high) force was established for competition rivalry & threat from substitutes, a moderate (medium) force for bargaining power of buyers and a weak (low) force for bargaining power of suppliers & threat of new entrants. The analyst may also comment about the strategies implemented by the company to combat these external factors and minimize their negative impacts.
Financial Analysis
Financial analysis section highlights the financial strengths and weaknesses of the business. It will give details regarding (a) historical financial performance and (b) a forecast of future projections.
(a)Historical financial performance– : Items such as revenue and earnings growth trends, debt load, operating cash flows, working capital, etc. are most commonly researched. Readers should observe comparisons of these line items over a certain period to get an idea of how company performed in the recent past.
(b)A forecast of future projections- : A prior condition to forecasting is to adjust or recast the historical data in order to normalize the cash flows. This step is essential since it aids in an accurate demonstration of the full business earning potential. Afterwards, pro forma analysis is done to analytically show the projected status of the company. Here, reader should carefully examine the reasoning for assumptions used.
Remember that when it comes to financial statement analysis, “more is considered less”. In other words, every detail matters and the writer may choose to present as much information as deem appropriate by him/her either in the main report or as part of the appendix. The reason is that financial analysis evaluates whether a firm can profitably grow its operations and earn a return on its invested capital which is equal to or more than the required rate of return demanded by the stakeholders of the firm. Subsequently, this research will become the basis of future share price movements.
Valuation
Once the valuation professional has an overall picture of the company, it is time to utilize all the relevant data gathered, choose appropriate valuation models, apply the selected valuation methodology and finally, assign one numeric value in the form of intrinsic value or target price. Essentially the forecasts developed earlier are converted into a valuation output. This goes beyond just the inputting of the forecasted amounts in a model. Sensitivity and scenario analysis are common to understand the effect of change in one or more assumption(s) on valuation outcome.
The reader should focus on valuation methods used to derive to the reconciled value and why such techniques were selected. Commonly used approaches to valuation are (a) discounted cash flow (DCF) which is an income based method, (b) relative valuation which is a market based approach and (c) asset based approach. For example, one report read, “We issue a BUY rating on Maruti Suzuki India Limited (MSIL) with one year target price of INR 8,500 based on a weighting of income and market valuation methods which offers a 15% upside from the current stock level.”
Investment Risks
The key focus of this section is to address the developments which could go against the company and pose a threat to the recommended action. The risks can be classified into categories such as business risk, financial risk, operational risk, regulatory risk, etc. Let us again take the example of Maruti to understand this part. Few risks can be known in advance such as the volatility in JPY/INR exchange rate as Maruti has to pay royalty payments to its parent company in Yen. The fluctuations can be mitigated using appropriate hedging instruments. However, a market related risk such as 2019 NFBC crisis and its adverse impact on car sales is often unprecedented. Readers should carefully go through this section.
Conclusion
The article discussed the key features and common elements of an equity report. A good report should apprise its audience about the future prospects of the subject company and its stock price in an unbiased way. Remember to go through the investment risks properly as the entire story weaved by the author can take a different direction due to certain known & unknown limiting conditions .The reader should critique the analysis as to how several factors & assumptions may play out. Infact, one can take reading as an opportunity to explore new possibilities by carrying further research and make the reading exercise more effective. Lastly, be mindful that valuation reports use a lot of finance jargon & abbreviations and going through a report in a swift fashion may happen with experience.
Written by: Shivani Chopra, CFA
Key Reference: Equity Research Report Essentials by CFA Institute
Related Posts
