How to do Equity Research? Process, Valuation, Indicators & moreLast Updated Date: May 12, 2022
This article is inclined towards Equity Research which is a very important aspect of fundamental analysis.
We will go though the process of Equity Research, understanding financials, Valuation, Indicators & more.
What is Equity Research?
In simple words, equity research can be described as the study and analysis of different companies’ stocks for investment purposes.
In a broader sense, it also includes research about commodities and bonds. The primary purpose of equity research is to decide whether to buy, hold, or sell a particular investment.
An equity research analyst’s main job is to study the company, entity, or the entire sector, to derive meaningful insights.
The equity researcher uses both fundamental and technical analysis to understand the present position and future growth prospects of any company.
The information published by these analysts is used by private equity firms, retail investors, and investment banks to support their decision making.
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How to do Equity Research as a retail investor?
The professional equity researchers have access to a whole ocean of data and techniques for analyzing a company.
This is not the case with retail investors who have limited means. But, in the era of the internet, this problem becomes a little smaller.
Websites like money control allow investors to find all relevant data related to any company they wish to invest in.
We will discuss the stages involved in equity research concerning retail investors in the sections below:
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1st Step in Equity Research – Know about the Company
The first stage in the process of equity research is to understand the business.
This includes answering all the what, how, why, who questions related to the company. From a long term perspective, business understanding is a must.
If you are still wondering why you should indulge in this tiresome process of developing an understanding of the business and not just jumping into fundamental analysis, then the answer is simple.
Unless you understand the company you are investing in, you will not find the conviction to stay invested in that company.
The people who directly jump to the stock price analysis are the first to disinvest because of the market noises.
However, the ones who know the company, understand their long term perspectives ignore the bearish phase easily.
The smart investors are the ones who buy in the bear market, not sell. This is because they know the business and wish to have a stake in it.
And, what will be better time to buy that stake than when the prices are falling?
Now the question arises, how do you develop a business understanding?
Make a Checklist on Company
Below is a checklist of the things you should know about a company before investing in it:
- What the company does?
- Information about the promoters of the company
- Knowledge about the products and services offered by the company
- Where are the offices/manufacturing plants located?
- Is the plant being fully utilized?
- Information about the raw material required to make the company’s key offerings. This has to be done in order to understand the dependency on external sources.
- Knowledge about the clientele the company has.
- Details about the competitors in the market. This is very important to compare the performance of the selected company with others in the same industry.
- Knowing Industry Average – By knowing about the competitors, you can quickly evaluate how the company is performing compared to the industry’s average. This also gives information about the industry’s nature and whether the company is operating in a monopoly or an imperfect competition. The higher the competition in the market, the greater is the margins and higher is the sales efforts required to tap the end customer.
- Information about the significant shareholders of the company. It is essential to know about this because shareholders have decision-making abilities. Also, if good investors have their holding in the said company, then it becomes a trusting factor to invest in that particular company.
Also, Consider these points in your Checklist for Company Research
- Expansion and diversification plans of the company. This is an important consideration because this tells how ambitious the company is. The more innovative and creative the company is, the higher are the chances of growth in the long run.
- Uniqueness and innovation of the company. If the company you choose to invest in doesn’t offer anything unique to its customers, then there is a very high chance that the customers will switch to a cheaper alternative as and when it comes. The company you choose should have uniqueness about itself. Just, for example, Apple. There are so many mobile phone brands coming and going in the market, but Apple has always been a customer favorite brand!
- The external environment in which the company operates.
- Government and legal regulations binding on the company.
This is a small checklist of the things you need to look for before investing in a company. No good investor would want to risk their capital into something they don’t trust.
It is essential to understand that you are not just investing your resources for present development. Instead, you are investing your time and future into that company.
The checklist is just to get your thought process going. In case you find any red flags during this stage of your equity research, you should stop it right there and then! If you do not understand a business properly, you do not want to invest in it. This is a basic rule!
The technical will keep on fluctuating and changing, but the business’s fundamental understanding is what stays forever.
If, as an investor, you are not sure about the fundamentals, do not proceed further with that company. There are tonnes of better opportunities where you can invest your resources.
Equity Research 2nd Step – Understanding the Financials
The next stage in the process of equity research is looking at the company’s financial statements and understanding financial performance.
There are several indicators of financial performance which need to be understood. Some of them are explained below:
Profit and Loss Statement Indicators
Revenue Growth: Revenue is probably the first point of consideration while thinking about investing in any company.
A good company shows signs of the year on year growth in revenue. A steady increase is better than oscillating between growth and decline.
An investor should look for companies that have shown a steady uptrend in revenue figures every year.
Stable growing revenue also indicates the ability of a company to overcome the impacts of business cycles.
PAT growth rate: PAT is an indicator that holds great value in equity research. A steady growing PAT reflects the high efficiency of the company.
If industries are able to survive cyclical shifts and present stable flat PAT growth figures, they are good options for investing.
EPS: Earnings per Share are a profitability measure. If a company shows a similar growth rate for PAT and EPS, it indicates that it does not dilute the earnings by issuing new equity shares.
This is good news for existing shareholders. A growing EPS is also an indication of good management in control. Thus an increasing EPS is a green flag for investing.
Gross Profits: Gross profits are calculated using the following formula:
Gross profit= Net Sales – Cost of goods sold
Here, net sales = Sales – Sales returns
Cost of goods sold = The entire cost involved in making of the finished goods. This includes the cost of raw material, work in progress, wages, fuel, etc.
In order to find if the company is worth investing in or not, gross profit margins (GPM) are used.
Gross profit margins are calculated as,
GPM = (Gross profit/ Net Sales)*100
For an investment to be successful, a GPM of 20% is considered good.
Balance Sheet Indicators:
Debt: Higher the debt, higher will be the financial leverage. Hence, a company with high debt in the balance sheet comes with a higher risk.
It also means that the company has high financial costs. This would lower the dividend payments and overall profits of the company.
If you see increased growth in business, you should definitely check the debt in the balance sheet.
Development on the cost of financial risk is not a prudent decision. A business needs to manage its debts efficiently.
Inventory: This factor comes into consideration, usually for manufacturing concerns. If you are looking to invest in a manufacturing company, you need to check their inventory management.
High inventory days lead to a high operating cost. It also indicates inefficiency on the part of the administration.
An increasing inventory, with a growing PAT, is a sign of the overall growth of the company.
Bills receivables: The bills receivables are studied in relation to the overall sales figures. Higher receivables indicate credit sales.
It is not considered a good sign while looking from the investor’s perspective. This is because the reason for high receivables can be pushed sales by the salesforce to meet targets.
There is also an increased risk of bad debts. This figure can be considered a big red flag if it’s a significant portion of the sales figure.
Other Critical Indicators include:
Return on Equity: RoE can be calculated as,
Return on equity= (Net profit/ Shareholders’ equity)*100
RoE measures the returns earned by a shareholder for every unit of capital they invest in the business. It helps an investor understand how efficient a company is in generating wealth for its shareholders.
This is undoubtedly an important consideration while doing equity research. Higher the RoE, the better the investment is.
Cash flow from operations: Just by looking at the cash flow statement, one can analyze how profitable a company is in terms of its operating efficiency.
In order to be a green signal for investment, the company must generate enough cash flows to cover its operating expenses.
A company that doesn’t have a positive cash flow from operations should not be considered for investing. The business which manages to keep a stable figure in this category is safe investment.
3rs Step in Equity Research : Valuation of Stock Price
The third and final step in the process of equity research is finding the company’s intrinsic value estimation.
Stock valuation becomes necessary to understand whether the company’s stock price is overvalued or undervalued, or fair priced.
A smart investor would never want to buy a stock that is worth 1/10th of its market price. The best investment is made when the stocks are trading below their intrinsic value.
Now the next question that arises is how to calculate intrinsic value? The intrinsic value of a company can be best calculated using the discounted cash flow method.
DCF analysis is one of the most commonly used techniques to understand whether a company is worth investing in or not.
How to do a Discounted cash flow analysis?
By following the below stated steps in the same order, one can quickly arrive at any stock’s intrinsic value:
(For understanding, here we are calculating the value after ten years.)
- Calculate the average of the last three years’ FCF of the company.
- Multiply the calculated value of Future cash flows with the expected growth rate. This gives you the future value of FCF.
- The net present value of this future cash flow is calculated by dividing it by the discounting rate.
- Repeat this process for all the ten years to arrive at the present values of all the future cash flows.
- Add these to arrive at the Net present value of the FCF for all ten years.
- Now calculate the terminal value. This is done by using the above-given formula.
- Add the NPV of 10 years FCF to the terminal value. This gives you the discounted market capitalization amount.
- Now divide the market capitalization amount with the company’s total outstanding shares to arrive at the fair value of the stock.
4th Step in Equity Research – Intrinsic Value Band
DCF valuation is one of the most popular valuation techniques. However it comes with its own setbacks.
DCF valuation is done based on certain assumptions. Even small changes in these assumptions can lead to drastic changes in the intrinsic value derived.
Hence, it is advisable to make realistic assumptions based on some historic data and not just media clatter. The smarter way to find the intrinsic value is to create an intrinsic value band.
This means creating an upper limit and lower limit as a fair value, instead of just one solid figure.
The intrinsic value band can be calculated by adding and subtracting a certain error percentage. For example, if you assume a change of 10% in your calculations, then
Upper band= Intrinsic value*(1+0.1)
Lower band= Intrinsic value*(1-0.1)
So, now, the stock’s fair price would be anything between the upper and lower band.
This method of establishing an intrinsic value band helps reduce the errors of modelling associated with the DCF valuation.
Buying decision based on intrinsic value:
Now, after calculating the intrinsic value of the stock, it is time to compare it with the market value to arrive at a buying decision:
- If the intrinsic value is lower than the market value, then the stock is considered overvalued. Hence, investing in it would be a bad idea. This is the level where the investors should either decide to book profits and exit or hold on to their investment for a longer time. Entering the market at this price would undoubtedly be no good idea.
- If the stock’s market value is lesser than the intrinsic value band, then the stock is undervalued. This is the right time to invest.
- If the stock’s market value falls within the intrinsic value band range, then it is not advisable to go for a fresh buy. The investor can hold their existing positions.
Hence, it is advisable to buy a stock when it is undervalued compared to its intrinsic value.
Stages in Equity Research
In the first stage, the investor builds a basic understanding of the business the company is into. All the who, how, when, what, etc. questions about the company are answered at this stage.
It is here when the investor first tries to understand the industry, competition, and the overall management of the company he is looking to invest in.
If there is any red flag in this stage, then there is no point going further in the analysis. If the company looks like a good buy based on its necessary information, then in the second stage, you should look into the company’s financials.
The annual report and financial statements need to be studied thoroughly. All the critical business metrics like sales, profitability, and operational efficiency, need to be ensured.
After the company has cleared the first two stages, you can go ahead with the valuation process. The DCF valuation model is used to arrive at the fair value of the stock.
If the stock lies below the intrinsic value band created, then the investor should make the buying decision for the same.
In order to be a value investor, it is essential to go through all these three stages of equity research thoroughly.
Intelligent investors do not put their money into any company randomly. They analyze, understand the company first, and lend their resources to it later!
Wealth is created by investing in long term goals of the company. And the best time to invest is when the stocks of the company are undervalued.
Equity Research: Conclusion
Equity Research is an integral part of Fundamental Analysis. Although, it is a tedious task, but it will surely yield returns in the future.
There is no point in investing in a company that you do not know everything about. By investing in a company, you make your resources a part of that company.
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