How to Present Company Valuation Analysis in Equity Research Report

 

In this article, I’m going to explain various valuation techniques in equity research.

I will focus on fundamental and technical analysis.

I’ll also explains how to use the correct models for valuation and have proper and appropriate assumptions to back your projections.

This—the  valuation part—is  probably the most challenging part of the equity research report.

In financial markets, valuation is the technique of calculating theoretical values of organizations and their stocks.

The main usage of these techniques is to forecast future market prices, or potential market prices, and thus to benefit from stock price movement – stocks that are adjudicated as undervalued are purchased, while stocks that are adjudicated overvalued are sold off, in the expectation that undervalued stocks will, increase in value, while overvalued stocks will fall.

There are two key methods of valuation:

a. Fundamental Analysis

 

It looks at the actual financial status of the organization, like the financial statements such as the balance sheet, income statement and cash flows. This approach focuses on factors such as:

  • Experience of the company’s management
  • Overall outlook for the industry sector
  • Current and pipeline product lines of the company
  • Market share
  • Balance sheet and income statement

It tries to assess whether a company’s stock is undervalued or overvalued based on its business prospects.

It uses various methods to arrive at valuation:

The Dividend Discount Model (DDM) is a method used by fundamental analysts to compute what the market price of a stock should be.

DDM uses a present value calculation based on a stock’s projected future dividends. The stock is considered undervalued if the market price is less than this computed amount.

One problem with this method is that projected future dividends may be higher or less than those that actually transpire over time. The DDM is one of the oldest and most conservative types of valuation.

The Discounted Cash Flow (DCF) analysis represents the Net Present Value (NPV) of projected cash flows available to all providers of capital, net of the cash needed to be invested for generating the projected growth.

The concept of DCF valuation is based on the principle that the value of a business or asset is inherently based on its ability to generate cash flows for the providers of capital. To that extent, the DCF relies more on the fundamental expectations of the business than on public market factors or historical precedents, and it is a more theoretical approach relying on numerous assumptions.

A DCF analysis yields the overall value of a business (i.e. enterprise value), including both debt and equity.

Valuation multiples are the fastest way to value a company, and are useful in comparing similar companies. They try to capture an organization’s operating and financial status (e.g. expected growth) in a single number that can be multiplied by some financial metric (e.g. EBITDA) to get an equity or enterprise value.

Multiples are expressed as a ratio of capital investment to a financial metric attributable to providers of that capital.

Some common valuation multiples are:

Enterprise Value Multiples                       

  • EV / EBITDA
  • EV / EBIT
  • EV / Sales
  • EV / Unlevered Free Cash Flow

Equity Value Multiples

  • Price / EPS (“P/E”)
  • Equity Value / Book Value
  • P / E / Growth (“PEG Ratio”)

b. Technical Analysis

 

Technical Analysis is the prediction of future financial price movements based on an inspection of past price movements. It relies on charts and trends to predict future movements of a particular stock or market index. These are the key measures used by technical analysts:

1. Volume

The number of shares trading is considered a signal of strength or weakness. For example, if a stock price increases on strong volume, this is considered more significant than a price increase on weak volume.

2. Advance/Decline Ratio

This measures the overall health or “breadth” of the market by comparing the number of issues that increased in price against the number that decreased in price.

3. Support and Resistance

This refers to the levels where a stock price comes under pressure. The support level is the “bottom” line in a typical chart, while the resistance level is the “top” line. The following charts illustrate the support and resistance lines for typical stock charts.

You can get more about multiples on this page.

Now that we have briefly seen the different valuation methodologies, let’s see how and which to use while writing equity research report.

In the world of valuation, fundamental analysis and technical analysis are completely contrary sides of the spectrum. Earnings, expenses, assets and liabilities are all important considerations in fundamental analysis, while a technical analyst does not consider these numbers.

Which method works best is always argued, and many volumes of textbooks have been written on both of these methods. I believe that fundamental analysis is a more appropriate method of valuation and should be stressed on more while writing an equity research report. But that does not mean you discount technical analysis. You can go ahead and use both the methodologies in your report.

If you see the below example, here the analyst has used fundamental analysis to predict the future performance of the company. He has used historical data from financial documents such as balance sheet, income sheet and cash flows and predicted the performance for the next three years.

1x1.trans How to Present Company Valuation Analysis in Equity Research Report

Now here in the below example, the analyst has used multiples comparison where he has compared the multiples of the target company to some of its peers. This helps the reader get a quick understanding of the target company’s valuation as compared to its competitors.

1x1.trans How to Present Company Valuation Analysis in Equity Research Report

You can also provide various charts and graphs depicting valuation of the company and its projections.

Here are some links to get models for valuation that you can use while writing your equity research report:

Now You Try It

I hope you understood this chapter.

Please make sure that you read this carefully as this is one of the most important and challenging chapters.

The reader’s decision to buy or sell the stock will depend a lot on the projected performance of the target company. So make sure you use the correct models for valuation and have proper and appropriate assumptions to back your projections.

How to Present Financial Ratio Analysis in Your Equity Research Report

 
How to present Financial Ratio Analysis in your equity research report?

In this chapter, I will explain the importance of presenting financial ratio analysis data of the company in detail.

I will also explain the importance of financial and ratio analysis in an equity research report.  We’ll look at the different financial statements where you will get the data for calculating the ratios.

In the earlier chapter we learnt how to write industry analysis in equity research reports, Porter’s 5 forces model and PESTLE analysis.

Now that you have understood how to complete the industry segment, let’s move on to the next chapter which is financial and ratio analysis.

This is one of the most challenging segments of an equity research report as many times it’s difficult to decide what to put in this segment and what to avoid.

If you look at any annual report you find a lot of financial information being provided there. You have the four key financial statements:

  • Balance sheet
  • Income statement (profit and loss statement)
  • Cash flows
  • Statements of shareholders’ equity

Balance sheets show what an organization owns and what it owes at a fixed point in time.

Income statements show how much money an organization made and spent over a period of time.

Cash flow statements show the exchange of money between an organization and the outside world over a time period.

The fourth financial statement, called a “statement of shareholders’ equity,” shows changes in the holdings of the organization’s shareholders over a period of time.

Let’s look at each of the first three statements more carefully:
 

a. Balance Sheet

 
A balance sheet provides detailed information about a company’s assets, liabilities and shareholders’ equity. The following formula explains what a balance sheet shows:

Assets = Liabilities + Shareholders’ Equity

A company’s assets have to equal, or balance, the total of its liabilities and shareholders’ equity.

Assets are generally listed based on how quickly they will be converted into cash while Liabilities are generally listed based on their due dates. Liabilities are said to be either current or long-term.

A balance sheet shows a snapshot of a company’s assets, liabilities and shareholders’ equity at the end of the reporting period. It does not show the flows into and out of the accounts during the period.
 

b. Income Statements

 
An income statement is a report that shows how much revenue a company earned over a specific time period (usually for a year or some portion of a year). It also shows the costs and expenses associated with earning that revenue.

Income statements also report earnings per share (or “EPS”). This calculation tells you how much money shareholders would receive if the company decided to distribute all of the net earnings for the period.
 

c. Cash Flow Statements

 
Cash flow statements report a company’s inflows and outflows of cash. This is important because a company needs to have enough cash on hand to pay its expenses and purchase assets. While an income statement can tell you whether a company made a profit, a cash flow statement can tell you whether the company generated cash.

You can find more information about this at Beginners’ Guide to Financial Statements.

Please understand one thing that no single financial statement will tell you the complete story of any organization. But if you combine them, they provide very powerful information for investors.

Remember that good and correct information is the investor’s best device when it comes to investing wisely.

So now that we have seen the most important financial statements, let’s understand what we should include from them in our equity research report.

Always remember the principal “less is more”. This does not mean that you just give a brief snapshot of the financials of the company which might not be enough for the reader to make up his mind about the financial strength of the organization. It means give precise and relevant information which will help the reader quickly understand the organization’s financial health and take calculated decisions.

So now what do we put in our equity research report?

First thing to add is a brief financial snapshot or a summary. Refer the example given below.

1x1.trans How to Present Financial Ratio Analysis in Your Equity Research Report

 

You can see that here the analyst has given us the key financial information points for the quarter such as total income, total expenses, EBITDA and other profit figures.

Note that he has given the financial numbers for not just the current quarter, but has also for the last quarter as well as the same quarter last year. He has also provided the ‘year on year’ (YOY) change as compared to the last year as well as a ‘quarter on quarter’ (QOQ) change against last year’s quarter. This gives the reader a clear idea as to whether the company is doing better or worse as compared to these two time periods. So here, instead of giving the entire income statement, the analyst has given us only key information which will help the reader understand the financial strength of the organization.

You can also provide a snapshot of the annual financial figures in addition to the quarterly figures. By providing annual figures you give the readers a more detailed view of the organization and they can look at a whole year’s performance instead of looking at only a quarter’s performance.
 

1x1.trans How to Present Financial Ratio Analysis in Your Equity Research Report

 
In this example if you see, the analyst has given a snapshot of all the three key financial statements. You don’t need to print the entire statements here but only the key numbers which are really helpful in understanding the financial strength or performance of the organization.

You can also give historical figures for the last two or three years, with growth rates, which will give a much clearer picture to the reader about the growth or decline of the organization.

All this information is easily available in the organization’s financial reports.

Further, you can also give more details such as breakup of the revenue or earning figures or trends in various different margins over a period of time as shown in the examples below:

 

1x1.trans How to Present Financial Ratio Analysis in Your Equity Research Report

 

1x1.trans How to Present Financial Ratio Analysis in Your Equity Research Report

 

Thus first thing you have to do is to figure out which are the key financials that you want to show in your report. And then decide with how many different time periods you want to compare the current financials with. Again don’t forget the rule of ‘less is more’ while doing this.

Now that you have given a snap shot of the financials of the company the next thing is the look at key ratios.
 

d.     Financial Ratio Analysis

 
Ratio Analysis is a type of financial analysis that is used to get a quick indication of an organization’s financial performance in several key areas. The ratios can be categorized as Short-term Solvency Ratios, Debt Management Ratios, Asset Management Ratios, Profitability Ratios, and Market Value Ratios.

The calculation of ratios helps in the comparison of companies which vary in size. Ratios can be used to evaluate a company’s financial performance with the industry averages. In addition, ratios can be used as trend analysis to spot areas where performance has improved or deteriorated over a period of time.

Ratio Analysis should only be used as an initial step in financial analysis, to get a quick idea of a company’s performance and to understand areas which should be investigated further.

Some key financial ratios are:

  • Short-term Solvency Ratios
  • Debt Management Ratios
  • Asset Management Ratios
  • Profitability Ratios
  • Market Value Ratios
  • Equations (per share ratios)

You can get more information on ratio analysis on the below links:

Now that we know that there are so many financial ratios that you can calculate and present, which of them should you really put in your equity research report? Again use the rule of ‘less is more’. No need to give all the ratios that you can calculate. There are no marks for filling up pages. Only give those ratios which will help the reader make comparisons or take calculated decisions.

Some of the important ratios you should always provide are:

  • PE ratio (Price earnings ratio)
  • ROE (Return on equity)
  • ROCE (Return on capital employed)
  • CR (Current Ratio)
  • Margins such as Net Profit Margin, EBIT Margin, EBITDA margin, etc

 1x1.trans How to Present Financial Ratio Analysis in Your Equity Research Report

If you see this example, the analyst here has provided the key ratios such as PE, ROCE, ROE, margins, as well as asset turnover and net debt to equity ratio.

Note that most ratios will be in percentage (%) but some like working capital cycle will be in days while some will be in multiples. Please make sure you give these notations clearly to avoid any confusion to the reader.

You can also compare these ratios to earlier years or even with competing companies to give an even better comparable analysis to the reader.

Also it’s a very good idea to give interesting and informative graphs and charts about various financial intelligence data points in the report to make it interesting and at the same time informative.
 

1x1.trans How to Present Financial Ratio Analysis in Your Equity Research Report

If you see the above examples, the analyst here has given two interesting charts. One shows the growth in the company’s domestic sales, and other shows growth in the exports of the company. These charts supplement the financial information the analyst has given above in the tables.

All the financial information you might need for this section of the report is most of the times easily available in the financial reports of the companies. There are also various databases such as Bloomberg which provide this kind of information. For the ratios, either you can calculate the ratios, or even get then from financial portals such as Yahoo finance or Google Finance.

Hopefully, now you understand what financial intelligence and financial ratios to use in your equity research report and how to present them.

I would again like to reiterate that do not overload your report with loads and loads of financial information, which could put off the reader. Be as precise as possible, only give the information which is relevant and will help the reader take calculated decisions about the company. Always remember the golden rule – ‘less is more’!

 

Now You Try It

 

I hope you understood how to present financial ratio analysis in your equity research report.

Yes, it takes hard work to create something great.

But with this skill you already know ahead of time that your hard work is going to pay off.

I want you to read various equity research reports to understand various styles and methods of presenting financial ratio analysis

At the same time, start working on writing reports.

If you have a question or thought, leave a comment below and I’ll get right to it.

 

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