Different approaches of Equity Research

Equity Research is aimed at identifying the opportunities for wealth creation and an equity analyst tries to identify undervalued or overvalued stocks through both his expertise and by use of available research tools. An appropriate valuation of securities is imperative for arriving at the right investment decisions.

Top-down Approach

In top-down forecasting, analysts use macroeconomic projections to produce return expectations for large stock market composites, such as SENSEX, NIFTY, and S&P 500. These can then be further refined into return expectations for various market sectors and industry groups within the composites. At the final stage, such information can, if desired, be distilled into projected returns for individual securities. The top-down approach seeks to understand the big picture, i.e. the most significant trends. Analysts then draw up their forecasts on the basis of these insights. This enables them to determine the “right” asset allocation (bonds, real estate, equities, etc.) as well as market, sector and company selection and weighting.

When taking a top-down approach, analysts draw on economic information on sector-specific and technical aspects of stock market developments. This information includes e.g. the growth prospects of individual economies (GDP growth), inflation and deflation, unemployment, developments in foreign trade, consumer sentiment, oil price movements, stock market volatility, leading indices or sub-indices (such as small and mid cap or sector indices), etc.

Bottom-up Approach

The bottom-up forecasting begins with the microeconomic outlook for the fundamentals of individual companies. If desired, the forecasts for individual security returns can be aggregated into expected returns for industry groupings, market sectors, and for equity markets as a whole. The purely bottom-up approach does not consider analyzing and forecasting “macro-events” and constructing logical chains of argument. Systematic bottom-up investors concentrate on individual investment objects and not their “macro-environment”.

The focus is on analyzing individual companies using concrete, and as rule pre-defined criteria. The portfolio consists of shares that have individually met all of these criteria. These criteria may include e.g. key financial figures, growth forecasts, dividend payments, qualitative aspects, international focus, size, management stability, ownership structure, etc.

Discounted Cash Flow Models

The assumption underlying Discounted Cash Flow Model is that a business is worth the present value of the cash flows that it will generate into the future. It is the after tax cash flows available to shareholders till perpetuity. To calculate the after tax cash flows available to shareholders the analyst would need to calculate the revenues a business generates and deduct all the cash-based expenses that are incurred in obtaining those revenues (including taxes and capital expenditures). The DCF analysis takes two pieces of information to determine the present value of the cash flows.

An estimate of the cash flows into the future.
An assessment of the potential variability of those cash flows, called the discount rate.

The DCF analysis assumes that cash flows today and in the near-future are worth more than cash flows further into the future. How much more depends on the discount rate. The higher the discount rate (the more variable the cash flows) the less they are worth in the future. The total present value of the future cash flows of a business is called the Enterprise Value which is the total value of the business, including both debt and equity.

To calculate the value of shareholder equity Net Debt has to be subtracted from the Enterprise Value. Net Debt is the long-term borrowings (i.e. bank debt) less cash or equivalents. If the company has more cash than long-term borrowings that is fine – Net Debt is negative and so adds to Enterprise Value. Finally, to determine a value per share divide the value of shareholders equity by the number of shares outstanding.

Free Cash Flow Models

Free cash flow (FCF) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. It is a measure of financial performance calculated as operating cash flow minus capital expenditures.

Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value. Without cash, it is difficult to develop new products, make acquisitions, pay dividends and reduce debt.

FCF is calculated as follows,

FCF = EBIT (1-Tax Rate) + Depreciation & Amortization – Change in Net Working Capital – Capital Expenditure

It can also be calculated by taking operating cash flow and subtracting capital expenditures.