Equity research is one of the most aspired roles in the financial industry. As the name suggests, the role of an equity research entails studying a company in detail and publishing it, so that every retail investor does not have to go through the trouble of it and can simply study the research reports.
Broadly, the main duties performed by equity researchers are –
- Analyzing financial information,
- Preparing reports,
- Attending various meetings such as AGM and investor meets,
- Evaluate risks and opportunities,
- Help portfolio managers in decision making, etc.
Now, Let’s dig down on how to research a company:
Industry Identification & Analysis
The first and foremost part when researching a company is to understand –
- The industry it operates in
- What is the entire market size of that industry
- Forces on which the industry is dependent upon
- Key market players with the highest market share and their business model
- What are the potential opportunities and threats the industry is exposed to
- Is there any Govt. intervention in that industry
- Legal and political risks involved
- Tax and subsidy related policies in the industry, etc.
Doing the above research helps you arrive at a broad level decision as to whether the industry is cyclical, risky or a stable one. For example- A tobacco industry is highly exposed with tax rate issues and hence always trades at a comparatively lower valuation in comparison to a consumer staple industry.
Another example would be Airline industry, due to performance directly linked with global crude prices the industry is very vulnerable as it is not able to further pass on the increased cost to its customers and has to take a toll on its margins sometimes even negative.
By understanding the complete market size you can arrive at broad level figures as to what exactly is the market size and at what pace is it growing YoY, and if a company can achieve a 10% market share how much can the company grow.
Understanding the business model of the company:
Now, once you complete the industry research part and decide to move ahead in that industry, you need to understand the company’s business model in depth as to
- How the company runs its day to day operations
- Who are its end customers
- How is the company disrupting the industry
- How is it creating and serving a value different from its other competitive partners
- Is it into B2B or B2C model
- What is driving the revenues and what are the major expenses associated to drive the revenue.
Every company has a unique business model despite being in the same industry; let’s understand this with an amazing example:
DMart (Avenue Supermarkets), a mass market supermarket chain company which started its operations in the year 2002 came up with its IPO in 2017 and got listed at a 114% premium to its issue price on the listing day and as per the current market price (June 2020) it translates to a return of whopping 769%.
This is only because of the unique business model of the company. Major portion of expenses for such businesses is the monthly rental expense. However, DMart used to buy its properties or enter into 30 – 40 years of long term lease to curb out the yearly rental increments. As a result, over the period of time when the rentals decreased the margins of other competitors such as Big Bazaar, Dmart was able to get more efficient every year.
Also DMart operated on very few billing counters to reduce manpower requirement and to use much of its space to display a larger variety of products. Also, the company operates on a low interior cost concept which reduces the operational expenses.
So, this is how you need to find the key differentiating factors in a company from its competitors.
Analyzing the Financials Statements and ratios:
Once you understand the business model and other operational metrics of the company the next step is to analyze the financials of the company and figure out the company’s financial health. You need to dig down deep on the following statements:
- Profit and Loss Statements: This statement records all the incomes and expenses and gains and losses that a company incurs throughout the year. P&L helps you understand the factors driving the revenues and the costs and the expenses incurred to generate that revenue. For more insight you should compare the P&L statements of the company for last couple of years to see the trend off all the items.
- Balance Sheet: It is a statement that records a company’s assets, liabilities and equity as of that date. The balance sheet gives insights into the capital structure and the net worth of the company.
- Cash Flow Statements: This is probably the most crucial statement out of all three, as it gives insights into the amount of cash entering and leaving the company through different activities. It shows how well a company is able to manage its cash positions, pay its obligations and fund its further capex.
These three statements contain the most crucial set of information and when compared with previous year statements, they give the trend and path the company is following and help in creating future projections as well.
Another important aspect is to perform Ratio analysis using the financial statements and arriving at key figures to access the financial health of the company from different aspects.
Performing Valuations DCF, Trading & Transactions Comps:
The last part in the research is to arrive at the intrinsic value of the company. Once you arrive at the intrinsic value you compare it with the current market value and if the intrinsic value you arrive at is higher than the market value it’s a buy and sell in case the market value is higher than the intrinsic value
DCF (Discounted cash Flows)- Under this method you compute the future projected Free cash flows based on some set of assumptions and then discount them to the present value. Mainly there are two cash flows that are computed and discounted:-
- Free Cash Flow to Firm (FCFF) – as the name suggests, it is the cash flow left after paying all the expenses and the capital expenditure that is left for both the capital providers equity and debt.
- Free Cash Flow to Equity (FCFE) – this is free cash to firm – debt payments ie- only that which is left over for the equity shareholders.
After the computation of cash flows, you discount them with the appropriate discount rate to arrive at the present value.
Transaction Comps- Here, the value is derived by comparing M&A transactions in the same industry in the recent past, the valuations at which those deals took place and an average multiple of all those deals is arrived and the company is valued at that average multiple of all those recent deals in the industry.
Trading Comps- Here the multiples at which all the other companies in the industry are trading at is calculated and an average of all those multiples is applied to the target company and the value is derived. The most common multiples used are P/E ratio, P/B Ratio, P/Sales, EV/EBITDA.