Equity Analysis

Chapter 8

Robinson, Munter, Grant

 Learning Objectives
• Understand equity analysis and its role in
investment recommendations
• Define Gross Domestic Product
• Explain Financial Reporting Conservatism
and Quality
• Articulate AIMR’s Code of Ethics and
Professional Conduct

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 Analysts
• Buy-side
– Work for an institutional investors (mutual fund)
– Make internal recommendations regarding the purchase
of equity securities
– Might review reports of sell-side analysts
• Sell-side
– Work for brokerage firms
– Issue reports for retail and institutional customers

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 Valuation
• Current value V0 is a function of
– Present value of next year’s cash flow, CF1
– Required rate of return, r
– Expected constant growth rate, g

CF1
V0 
rg

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 Equity Analysis
Provides information regarding
1. The future cash flow generating ability of
the firm
2. The growth (or lack thereof) of those cash
flows
3. The risk of those cash flows, and
4. The risk-free rate commanded by the
market
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 Top-Down Analysis
• Begin at highest (economy) level
– Allocation between domestic and international
equities
• Market sectors
• Industries (within a sector)
• End with evaluation of specific companies

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 Bottom-Up Analysis
• Begin with individual companies
– Look for key strengths
• Screen large data bases for attractive
characteristics
– Compustat, Bloomberg, Baseline
• Search for a combination of characteristics

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 Macroeconomic Analysis
• Gross Domestic Product (GDP): total value of all
final goods and services produced within a
country.
– Nominal, measured in current dollars
– Real, adjusted for changing prices
• Gross National Product (GNP): total value of all
final goods and services produced by factors of
production owned by citizens of a country
regardless of production location
• Growth rates of both can be used as an initial
estimate of a firm’s growth rate
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 Business Cycle
• Expansion
– Period of economic growth
– Increased need for PP&E, labor, inventory
• Peak – high point following expansion
• Recession
– Contraction following a peak
– Rising unemployment, decreased need for factors
of production
– Two quarters of falling real GDP

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 Business Cycle

• Trough – low point following recession

• Depression
– Prolonged and severe recession
• Some sectors and industries will perform better
in some stages of the cycle than in others.
• Cyclical firms are sensitive to stages of the
economic cycle.

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 Inflation
• Consumer Price Index (CPI) measures inflation of
a market basket of consumer goods
• Producer Price Index (PPI) measures inflation at
the wholesale level
• Higher inflation, higher required risk-free rate of
interest
• Impacts all companies and all industries (to
varying degrees)

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 Economic Indicators
• Leading indicators
– Move in advance of the business cycle
– Unemployment claims, new orders
• Lagging indicators
– Follow behind the business cycle
– Average duration of unemployment, average prime rate
• Coincident indicators
– Move with the business cycle
– Industrial production
• Used in sector analysis, for example
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 Sector/Industry Analysis
• Assess the ability of companies within the
industry to generate cash flow
• Assess the potential growth of that cash
flow
• Assess the risks related to receipt of those
cash flows
• Assess the industry’s ability to grow
relative to the overall economy
– ƒ(demand for the industry’s good and services)
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 Porter’s 5 Competitive Forces that determine
industry profitability
1. Threat of New Entrants
- Capital requirements, government policy, access to distribution
2. Bargaining Power of Suppliers
- Supplier concentration, switching costs, differentiation of inputs
3. Bargaining Power of Buyers
- Buyer concentration, price sensitivity, brand identity
4. Threat of Substitute Products or Services
5. Rivalry Among Existing Firms
- Industry growth, barriers to exit, current industry concentration

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 Company Analysis
1. Understand the business
2. Evaluate past performance
3. Forecast performance
4. Value the company
5. Make an investment recommendation

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 Understanding the Business
• Gain an understanding of the products and services
provided by the company and the market for those
products and services
• Talk to employees, suppliers, competitors
• Interview customers
• Utilize the company’s products or services

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 Evaluating Past Performance
• Understand reported financial information
• Common size and ratio analysis
• Consider efficiency, liquidity, solvency, cash flow
and relative valuation
• Understand US GAAP and IAS
• Financial reporting quality and conservatism

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 Examples of Fraud Risk Factors (AICPA)
• Threatened financial stability or profitability
• Management under pressure to meet third party expectations
• Director’s personal wealth threatened by entity’s financial
performance
• Industry provides opportunities for fraud
• Ineffective monitoring
• Complex/unstable organization
• Ineffective communication/support of ethical standards
• History of violations

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 Financial reporting quality

• The degree to which financial reports fairly reflect

the underlying economic performance and financial
position of the company.
• Statements most fairly reflecting underlying
performance of are of high quality.
• Statements that do not fairly reflect underlying
economic performance are of low (or no) quality.

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 Financial reporting conservatism
• The degree to which accounting methods and
assumptions tend to report lower current earnings,
cash flow or net assets relative to the other methods.
• Firms should choose the most conservative of the
appropriate accounting methods and assumptions.
• High FRC does not necessarily mean high FRQ.

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 Signs warning poor FRQ/FRC
Revenue recognition (AICPA)
• Early revenue recognition
• Recognize revenue from barter transactions
• Classification of non-operating income as part of
operations
• Revenue growth out of line with industry, inventory,
receivables or operating cash flow
• Large proportion of revenue in last quarter for non-
seasonal business

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 Signs warning poor FRQ/FRC
Expenses (AICPA)

• Deferral of expenses through capitalization

• Lessee use of operating lease
• Use non-conservative estimates
• Use of reserves
• One-time charges recorded as non-operating
activities
• Excessive use of stock option compensation not
recorded as an expense

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 Signs warning poor FRQ/FRC
Other (AICPA)

• Use of aggressive acquisition accounting

• Use of non-consolidated special purpose entities
• Large changes in deferred tax assets/liabilities
• Sales of receivables with recourse and removal from
the balance sheet
• Use of unconsolidated joint ventures or equity
method investees where substantial ownership exists

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 Forecasting Performance
• Based on evaluation of past performance,
economic/industry conditions and expected
changes
• Pro-forma (projected) financial statements
• Projection of future earnings
– Use earnings model or statistical projection

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 Valuing the Company
• Determine the appropriate price for making
an equity investment
• Is the intrinsic value higher or lower than
the current market price?
• Specific methods discussed in Chapter 10
– Discounted cash flow
– Market-multiple
– Residual income

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 Making an Investment
Recommendation
• Current price of subject company’s
securities
• Results of valuation
• Risks of investment
• Investor’s risk tolerance, objectives and
time horizon

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 Analyst’s Report
• Document and communicate analysis, facts
and opinion
• Buy-side: used within institutional
investment firm
• Sell-side: used outside brokerage firm
• Buy/Attractive
• Hold/Market Perform
• Sell/Market Underperform
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 Analyst’s Report
Contents
• Table of contents
• Summary and Investment Conclusion
• Business Summary
• Risks
• Valuation
• Historical and Pro Forma Tables

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 AIMR Standards
• Act with integrity, competence, dignity and
in an ethical manner
• Practice in a professional and ethical
manner
• Maintain and improve competence
• Use reasonable care and exercise
independent professional judgment

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 Summary
• Equity analysis
• Economic indicators
• Financial Reporting Conservatism and
Quality
• AIMR’s Code of Ethics and Professional
Conduct

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