Equity Research and Valuation

Prof. Akhil Shetty

Introduction
 Equity Valuation is estimation of an intrinsic value based on variables perceived to be
related to Fundamentals of the respective company or its peer
 Intrinsic value of any asset is the value of the asset given a hypothetically complete
understanding of the asset’s investment characteristics
 For any particular investor, an estimate of intrinsic value reflects his or her view of the “ true
” or “ real ” value of an asset
 Intrinsic value can be estimated with going concern assumption or Liquidation assumption
 Analysts gather and process information to make investment decisions, including buy
and sell recommendations
 Fundamental analysis uses information about the economy, industry, and company as
the basis for investment decisions
 Examples of fundamentals are unemployment rates, gross domestic product (GDP) growth,
industry growth, and quality of and growth in company earnings
 The fundamentals to be considered depend on the analyst’s approach to valuation
 Analyst can use Top – Down or Bottom Up Approach to valuation
Sources of financial information
 An external auditor’s report providing assurance
 A Statement of Comprehensive Income
 A Single Statement of Comprehensive Income Or
 An Income Statement And A Statement Of Comprehensive Income
 A Statement of Financial Position
 A Statement of Cash Flows
 A Statement of Changes in Equity
 Footnotes
 Are considered an integral part of a complete set of financial statements
 Letter from the Chairman of the company
 A report from management discussing the results (typically called management
discussion and analysis [MD&A] or management commentary)
 A governance report describing the structure of the company’s board of directors
Pointers to look in Management Discussion &
Analysis (MD&A)
 The nature of business
 Impact of inflation, changing price, material events and uncertainties that may cause
the future operating results
 Might provide information about off balance sheet obligations and contractual
commitments
 Also discuss about critical accounting policies that require subjective judgment
 Forward looking disclosure such as planned expenditures, new store openings, or
divestitures can be useful for projection
 Management objectives and strategies
 Companies significant resources, Risk and Opportunities
 Results of Operations
 Critical performance measures
Sources of financial information
 Corporate responsibility Report
 Proxy statements
 Press Releases & Interim Reports
 Information on the economy, industry, and peer companies is useful in putting the
company’s financial performance and position in perspective and in assessing the
company’s future
 In most cases, information from sources apart from the company is crucial to an
analyst’s effectiveness
 For example, an analyst studying a consumer oriented company will typically seek
direct experience with the products (taste the food or drink, use the shampoo or
soap, visit the stores or hotels)
 An analyst following a highly regulated industry will study the existing and
expected relevant regulations
 An analyst following a highly technical industry will gain relevant expertise
personally or seek input from a technical specialist
 In sum, thorough research goes beyond financial reports.
Industry analysis
Porter 5 Forces
 The threat of entry to the industry, which depends on barriers to entry, or how difficult it
would be for new competitors to enter the industry
 Industries that are easy to enter will generally be more competitive and will have low
pricing power than industries with high barriers to entry
 The power of suppliers, which may be able to raise prices or restrict the supply of key inputs
to a company
 For example, workers at a heavily unionized company may have greater bargaining power
as suppliers of labor than workers at a comparable non- unionized company
 Suppliers of scarce or limited parts or elements often possess significant pricing power
 The power of buyers, which can affect the intensity of competition by exerting influence on
suppliers regarding prices (and possibly other factors such as product quality).
 For example, auto parts companies generally sell to a small number of auto
manufacturers, which allows those customers, the auto manufacturers, to be tough
negotiators when it comes to setting prices
Porter 5 Forces
 The threat of substitutes, which can negatively affect demand if customers choose other
ways of satisfying their needs
 For example, consumers may trade down from premium beers to discount brands during
recessions. Low- priced brands may be close substitutes for premium brands, which,
when consumer budgets are constrained, reduces the ability of premium brands to
maintain or increase prices
 The rivalry among existing competitors, which is a function of the industry’s competitive
structure
 Industries that are fragmented among many small competitors, have high fixed costs,
provide undifferentiated (commodity- like) products, or have high exit barriers usually
experience more intense rivalry than industries without these characteristics
 Although all five of these forces merit attention, the first and fifth are particularly
recommended as a first focus for analysis
 investigating these two forces, the analyst may become familiar in detail with an
industry’s incumbents and potential entrants, and all these companies’ relative
competitive prospects
Two Factor Analysis of Industries
Two Factor Analysis of Industries
Industry Life- Cycle Model
Company Analysis
 Elements That Should be Covered in a Company Analysis
 provide an overview of the company (corporate profile), including a basic
understanding of its businesses, investment activities, corporate governance,
and perceived strengths and weaknesses;
 explain relevant industry characteristics;
 analyze the demand for the company’s products and services;
 analyze the supply of products and services, which includes an analysis of
costs;
 explain the company’s pricing environment; and
 present and interpret relevant financial ratios, including comparisons over
time and comparisons with competitors
 Company analysis often includes forecasting the company’s financial statements,
particularly when the purpose of the analysis is to use a discounted cash flow
method to value the company’s common equity
A Checklist for Company Analysis
 Corporate Profile
 Industry Characteristics
 Analysis of Demand for Products/Services
 Sources of demand
 Product differentiation
 Past record, sensitivities, and correlations with social, demographic, economic,
and other variables
 Outlook—short, medium, and long term, including new product and business
opportunities
 Analysis of Supply of Products/Services
 Sources (concentration, competition, and substitutes)
 Industry capacity outlook—short, medium, and long term
 Company’s capacity and cost structure
 Import/export considerations
 Proprietary products or trademarks
A Checklist for Company Analysis
 Analysis of Pricing
 Past relationships among demand, supply, and prices
 Significance of raw material and labor costs and the outlook for their cost
and availability
 Outlook for selling prices, demand, and profitability based on current and
anticipated future trends
 Financial Ratios and Measures (in multi- year spreadsheets with historical and
forecast data)
 Activity ratios
 Liquidity ratios
 Solvency ratios
 Profitability ratios
A Checklist for Company Analysis
 Financial Ratios and Measures (in multi- year spreadsheets with historical and
forecast data)
 Growth rate of net sales
 Growth rate of gross profit
 EBITDA
 Net income
 Operating cash flow
 EPS
 Operating cash flow per share
 Operating cash flow in relation to maintenance and total capital
expenditures
 Expected rate of return on retained cash flow
 Debt maturities and ability of company to refinance and/or repay debt
Valuation of Equity Shares
 Present value model (synonym: Discounted Cash Flow (DCF)model)
 These models estimate the intrinsic value of a security as the present value of the
future benefits expected to be received from the security
 Analyst particularly use forecasted cash flow like Dividend or Free cash flow to
equity (FCFE) or Free Cash flow to Firm (FCFF) to find the intrinsic value
 Multiplier model (synonym: Relative Valuation model)
 These models are based on law of one price which states that similar businesses
should trade at similar multiples
 These models are based chiefly on share price multiples or enterprise value
multiples (P/E, P/B, EV/EBITDA & EV/Revenue)
 Asset- based valuation models
 These models estimate intrinsic value of a common share from the estimated
value of the assets of a corporation minus the estimated value of its liabilities and
preferred shares
 The estimated market value of the assets is often determined by making
adjustments to the book value (synonym: carrying value) of assets and liabilities