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:
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.
Suggested: Read more about Equity Research 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.
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.
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.