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I took what I learned from business school as well as work and simplified it here. This article is not in any way comprehensive. However, I do believe it offers general insight into the research and evaluation process of an investment bank.
As a disclaimer, my process is my routine. You should only use this to come up with your very own research and valuation methods. To apply our free Excel effectively, you should read the short steps below. We will start immediately with the economic analysis.
You should apply a “top-down” approach when analyzing stocks to buy or sell. This means that you start by analyzing the global economy and work down to your company itself. By doing this, you avoid overlooking important signals that can significantly impact the value of your stock.
First, you should look at global economic drivers. You should ask questions like what is driving global growth? What countries lead the way? And, you should be especially aware of the state of the individual economies in which your company conducts business. For most of you, this should be the United States.
You should understand and analyze the U.S economy through benchmarks such as GDP, inflation rates, unemployment rates, interest rates, and oil and other commodity prices. You should put together a picture of where the economy is likely to be in the short-term (1 year) and long-term (1 year +) and how that will affect your investment.
The goal is to understand the general economic consensus. You do not need to develop a forecast of GDP or interest rates. You can use a PEST analysis framework to identify and monitor relevant macro-economic factors that may affect your company in the future.
In the end, you should understand what the experts are saying about the global and domestic economy and how they might influence your investments. We provide you with a list of free resources below.
Before you conduct a detailed analysis of your investment, you should understand what sector and industry your company sits in. As an individual investor, you should aim to become an expert within one or two industries.
Certain industries are more sensitive to macroeconomic factors than others. How does your industry compare to other ones? And what point of the business cycle is your industry in? Each company has a Global Industry Classification Standard (GICS) number that assists you in locating a company’s sector and industry.
Firms in the same industry generally produce similar products and services. You should identify key ratios and statistics that capture the financial health of all companies in that industry.
The key here is to identify relevant and irrelevant factors that affect the value of your company. Looking at analyst reports is a good way to determine popular ratios and statistics. After you do this, you need to determine the competitive structure of the industry.
To understand the competition, you need to understand where your company stands compared to its competition. To do this, you can use SWOT and Porter’s 5 analyses to evaluate things like strength, weakness, opportunity, threat, and level of competition.
Companies often mention their competitors somewhere in its 10-K. Sometimes the list is good and other times the list is bad. You often need to add or subtract to the list until you are completely satisfied.
For example, McDonald’s competitors are companies in the fast-food industry. To find the right competitors, you also need to consider market capitalization and products. You cannot compare McDonald’s to a regional chain like Whataburger. You also cannot compare McDonald’s to The Cheesecake Factory, a sit-down restaurant.
Finding the right competitors helps you determine how your company performs among its peers.
For the next section, you will look at management. Management sets the “tone at the top” and this step cannot be overstated.
When you buy a company, you are buying ownership in that company. You are placing your trust in management’s vision for the future. You need to know that your company has the right incentive structure and key decision-makers.
The board of directors oversees management. We should evaluate what each member brings to the table. Who are they? What have they done in the past? And who are they affiliated with?
Management incentives are defined by the compensation structure put in place. Who makes up the management team? And do managers make money from beating short-term or long-term benchmarks?
You can find most of this information on a company’s website. A great management team can position the company for long-term success. After you answer these sets of questions, you can move on to the most important section: “revenue driver”.
As an analyst, you need to understand how a company makes money. A single company can make money in many different ways. For example, a company like Tesla sells cars, rent out cars, and provides services. Selling cars is Tesla’s main revenue driver. This is because car sales generate almost all its revenue. When you spend your time forecasting revenue, you will spend most of that time on the main revenue driver.
You must determine exactly which segment drives the most revenue. This is pretty simple to do most of the time. However, it gets confusing when you deal with more complex business structures in which one type of revenue does not dramatically stand out among its peers.
All businesses have a revenue driver. Publicly traded companies, or companies traded on the U.S stock exchange, must provide an audited balance sheet, income statement, and statement of cash flow each year. The aforementioned documents are always posted on the SEC’s Edgar database, free for anyone interested.
You need to be aware that companies often deploy accounting tactics to make themselves look better. Accountants are always dying at the opportunity to find a way to report better numbers.
To avoid all the trickery, you need to decipher financial statements yourself. This is why websites that provide general analysis are only useful during the start of your analysis. Simple cookie-cutter approaches often miss important details.
We only want to invest in companies that perform well and provide you greater returns. Therefore, you must first understand the company’s main revenue driver. After you understand the revenue driver, ask yourself questions like why would revenue increase or decrease in the future? We will look more into this concept when we forecast revenue later.
Understanding accounting distortions can help you better predict the future and gauge the real performance of a company. Companies either apply aggressive accounting or conservative accounting. Companies with aggressive accounting are overvalued and companies with conservative accounting are undervalued.
As an analyst, you need to know which one of these conditions affects your company. For example, companies can’t capitalize on research and development expenses until the R&D becomes “technically feasible”. Therefore, R&D heavy companies are often undervalued and have high PE ratios. Key accounts to analyze here include items such as taxes, research & development, revenue, goodwill, and contingent liabilities.
When you think about accounting distortions, there are three main reasons why a company’s financial statements are distorted: strict accounting rules, the use of estimates, and intentional manipulation.
There are many ways to compute financial ratios. Sometimes, a ratio is calculated before tax and other times after-tax. Maintaining an “Apple” to “Apple” comparison is the most important thing to remember. You do not want to compare a before tax ratio to an after-tax ratio
More importantly, you need to determine if the financial ratios are in line with your expectations. Ratios often do not provide answers, they only tell you where to look for answers.
Managers know that investors use ratios to analyze companies. Therefore, managers often window dress ratios and make them appear more attractive. Therefore, it is your job to undo any distortions.
Ratios help us understand growth, profitability, turnover, margins, and leverage. Once you understand areas highlighted by a company’s financial ratios, you can move on to the cash flow analysis.
Cash Flow Analysis
Companies can report huge revenues even when they are not generating money. Revenue is based on the rules of accrual accounting. Therefore, analyzing cash flow can help us determine the quality of our revenue.
When there is a large gap between cash flow and revenue, we should further investigate a company. We should determine the free cash flow to equity holders and what the firm does with its cash historically. Does the money go to debt holders, equity holders, or back into the company? Once you have a basic understanding of this, you can use it in your forecast by adjusting your forecasting assumptions of cash use and source in the future.
Sales are the most important thing in forecasting. There are so many different ways to forecast a company’s future sales. You can use historical sales growth figures and forecast everything else as a percentage of sales. However, this is not the most accurate method of forecasting.
Another way to start is by using industry sales growth first. More specifically, companies with more market share just grow like the industry benchmark and companies with less market share grow based on its firm-level activities.
Either way, when you look at an individual firm, you need to find the right revenue driver. For example, predicting McDonald’s sales growth would involve looking at its number of stores. You can then forecast new store numbers and how much sale is generated from each new store. By doing this, you can build a more accurate model of sales.
After you forecast sales, we can forecast margins and turnover, using historical trends. You can use margins and turnovers to forecast the entire income statement and balance sheet.
Please note individual items will need to be adjusted if your forecast does not agree with your current understanding of the company. This involves a back and forth effort that takes multiple attempts to perfect.
Weighted Average Cost of Capital
The weighted average cost of capital (WACC) is simply a discount rate applied to valuation models. The WACC is made up of two parts: equity and debt. The equity portion of WACC is determined by Capital Asset Pricing Model (CAPM) and the debt portion is determined by our cost of debt minus a tax shield.
Although the model is important for analysis, it is simply an estimate. You should not be afraid of this model. If all else goes wrong, you can just use 10-12% to discount your future estimates.
Capital Asset Pricing Model (CAPM)
= [rf + (rM – rf)*b]
The CAPM formula does not relate much to your company, yet it measures your cost of equity. To break the formula down, it uses the return of a risk-free rate (10-year Treasury bond), the average return on the equity market (S&P index), and finally our company’s beta. If you think about the CAPM model, the only value here that relate to our company is the beta.
This is problematic in a big way. Riskiness and beta do not always go hand and hand together. A company like IBM has had huge swings in beta across time yet the financial statement has always been sound in practice.
Weight average cost of capital (WACC)
[wd*rd*(1-T) + we*re]
The WACC adds the CAPM and the cost of debt together. The cost of debt includes a tax shield, meaning that debt financing is more attractive than equity financing. Tax savings from debt are always deducted from your cost of debt. Although we all know that debt is riskier than equity, the model here will not pick this up.
Using the WACC model, you sometimes see more risky companies being overvalued. For simplicity’s sake, you can just use a 10 to 12% discount rate. This screen out any company that can damage us and is quite high in terms of required returns, giving us a good margin of safety.
In terms of actually valuing your company, there are many commonly used methods. The most popular methods are the discounted cash flow model and the residual income model.
Discounted Cash Flow Model
The discounted cash flow model requires you to build a projected cash flow statement of the future. Then you take the future sum of “free cash flow”, or cash flow from investing and operations, and discount that amount by a discount rate (WACC).
In total, you measure a company based on how much cash you expect the company to make in the future. DCF is one of the most popular methods of valuation.
The DCF is easy to use and understand. However, the model relies on numerous assumptions to operate. The DCF model heavily relies on WACC. However, we know that WACC underestimates debt risk. Besides, your cost of equity is only determined by your beta, which might not be the best estimate of risk.
Residual Income Model
On the other hand, the residual income model says that the net income on our financial statement accounts for everything other than the cost of equity. Therefore, “residual income” is net income minus our equity costs.
The model projects residual income earnings over many years and discounts the future sum of our residual earnings into the present. Simply put, when ROE is greater than the Cost of Equity, you earn future values.
The residual income model is great for looking at economic profitability. The model relies heavily on reported data. Therefore, it is important to take time and determine the accuracy of your forecasts.
At the end of the day, even with so much analysis, we still see that valuation is largely based on estimates and luck. As an analyst, the best thing we can do to be precise, have a large margin of safety, and take the time to perfect your analysis.
All in all, you should focus mainly on one or two industries, consider the effect of economics, and value companies conservatively.