How to conduct a Equity Research?
Day 1 of Covering Finance related topics
People often think about how Big investors make money by selecting the right stocks? which leaves them with tremendous wealth and they do it repeatedly for decades, without failing. Well, they all are avid readers which leads them to read about the finances of the Industry then the sector then the company, and here comes the skill called Equity Research.
Before we discuss equity research, it’s important to understand the concept of equity. Equity is the full ownership of an asset. Equity research, or “securities research,” refers to the process investment banks use to understand a company's overall equity or value.
Equity analysts, often working within an investment bank, lead this process. They create documents that delineate the equity in question within the context of the business, its management, the broader industry, and the economic landscape.
The larger the investment bank, the more reports an equity research team will tend to produce, and the analysis included will be more detailed. Examples of analysis include
Review of how the macroeconomic/microeconomic picture is likely to affect the company
Operational changes or investments that are likely to affect the company’s performance
Review the company’s financial statements and explanation of changes
Projections on the status of the company’s revenue (and share price) and where it’s headed
Recommendations on whether to buy, hold, or sell the company’s equity
There are two types of Equity Research Reports, Buy side & Sell side.
Buy-side reports are available in the public domain, all the reports which we read in newspapers, websites, news, etc are buy-side equity reports. These reports are presented and made in such a way that any normal person can understand and act on them, mostly broking houses publish these reports for their clients.
Sell-side reports are specially made for Investment banks, Mutual funds, Hedge
funds, Private Equitys, Venture funds, or any kind of Institutional investor. These reports are highly confidential and not available in the public domain. They earn by selling reports or through commission bases.
In established Equity Research Houses, they first do the Economic, Market cycle, Government Policy analysis and then they come to the Sectorial analysis from which they find the best company to invest in for the long term.
In this article, you’ll read about how to do the company or equity research of any company step by step.
1) Management analysis :- This is the most neglected part of any research even fund houses make the mistake of ignoring the company's management, as management is the soul of any business they can either take it to the moon or burn shareholders cash in hell. Take any Big business in the world that has failed, it will all come down to bad capital allocation by the management (Rakesh Jhunjhunwala’s Research). So it’s very important to analyze the quality of management running the business. Here are the major checkpoints to analyze any company’s management of this world.
2) Financial Statement :- This is the part where everyone makes a mistake, Every business is different in nature, and every business will require different parameters to value it, so here comes the part where we will get into the books of business, the best way to measure the quality of any business is by using financial ratios like ROA, ROE, PEG, EPS etc.
Every sector requires different ratios to analyze it, ratios of service businesses will not work on manufacturing business and ratio manufacturing will not work on banking business, every sector is different. (Here i can’t cover every ratio, so i’ll suggest giving the Equity Derivatives & Research Analyst exam of NISM, it will help you understand the financial statements, and if you want to get advance go for CFA-1)
But here are some examples of the ratios which will help you to evaluate business at the macro level.
3) Cashflow statements :- A cash flow statement is a financial statement that portrays how businesses spend their cash. The statement includes detailed information about a business's cash inflow and outflow, meaning it keeps track of the amount of money that flows in and out as a result of business handling. Having cash available is a base requirement for businesses to stay solvent and avoid bankruptcy. It shows the Efficient Captial allocation of business.
Cash flow statements break down this flow of money into three different sections of cash-related activity:
Operating activities
This section of the cash flow statement details operating costs and profit items that are also found on an income statement, such as accounts receivable and payable, inventory, wages payable and income taxes payable. The operating activities section focuses on a business's main activities, like selling or buying merchandise and services.
Investing activities
This section includes information about the business's purchase or sale of long-term investments, such as property, buildings, vehicles, furniture or equipment. The investing activities section provides further details about a company's assets.
Financing activities
This section outlines all cash transactions from long-term liability and stockholder equity accounts, including notes payable, retained earnings and dividend payments. The financing activities section reflects the company's net cash flow, taking stock purchases and debt financing into consideration.
There are many different kinds of Cashflow statements but this can help you in analyzing the capital allocation of any business.
4) Financial Modules :- It helps in many ways from valuing the business to forecasting it’s revenue, assessing the risk in it, capital budgeting, and allocation. All of this is done by making different models like
Three-Statement Model
Discounted Cash Flow (DCF) Model
Merger Model (M&A)
Initial Public Offering (IPO) Model
Leveraged Buyout (LBO) Model
The sum of the Parts Model
Consolidation Model
Budget Model
Forecasting Model
Option Pricing Model
5) Key Risk and Investment decision :- Every business has it’s risks and downsides which can affect it’s growth in the longer term, The Market always respects volume growth, if a business is not able to show growth market will not give it the premium it deserves and stock price will not move or even it will decrease in the investment time frame, So it’s very important to note down the risk and also the managements view about it and how they’re trying to overcome it.
There are many other factors to consider while analyzing the business of any company which will give you the Microview and the above factors will help you in getting the macroview of it. Thank you!