Equity analysts are employed by investment banks and stockbrokers to research companies and provide investment ideas to their clients.
You can apply some of the techniques and metrics used by these financial professionals to your own investing process.
Typically, analysts focus on their domestic market, so many UK-based analysts will cover British companies exclusively.
They will also have an understanding of the UK market as a whole, looking at metrics like the average price to earnings (PE) ratio and dividend yield for headline indices in the UK, as well as understanding how stocks have performed in the past and whether we are in a bull or bear market.
They will also have an understanding of the composition of the different indices.
For example, the FTSE 100 does not really reflect what is happening in the domestic economy because approximately 70% of its constituent’s earnings are generated overseas. It also has a heavy bias towards certain sectors like resources and financials.
By contrast the mid cap FTSE 250 index has greater British exposure and a more balanced make up in terms of industries represented.
UNDERSTANDING SECTORS
Effectively covering all the industries represented on the UK stock market would be nigh on impossible so analysts will also limit themselves to a specific sector.
Such a tight focus would neither be practical or desirable for a private investor running a diversified portfolio but there is an important lesson to only invest in things you understand.
An analyst needs to know the different sensitivities of individual sectors as well as the key performance indicators for sector constituents. Essentially these are the yardsticks by which all companies in a sector can be judged.
For example, net asset value (NAV) - a company’s assets minus its liabilities - has far more relevance to the property sector with its investments in bricks and mortar than it does to the media sector where companies have few tangible assets.
UNDERSTANDING COMPANIES
The fundamental part of an analyst’s job is to understand individual businesses. An analyst note on a company will usually include two headline items - a ‘buy’, ‘hold’ or ‘sell’ recommendation (sometimes a variation on this theme like ‘overweight’, ‘equal weight’ and ‘underweight’) and a price target. It will also include the analyst’s forecasts for things like earnings and cash flow.
A price target is usually based on some measure of intrinsic or relative value and the methodology used to derive it will depend on the relevant sector and maturity of the company.
Having your own price targets for stocks in which you have an investment is a useful discipline. Even if you have a long-term approach, understanding if a company has become overvalued is important.
HOW TO VALUE A COMPANY
There are two key ways an analyst will approach the valuation of a company. The first is to look at it in absolute terms - assessing the firm entirely on its individual merits.
The second is to look at the company’s valuation using several well-established yardsticks and consider it relative to the market and its peers.
An analyst will often determine absolute value using a discounted cash flow (DCF) calculation. This is sometimes referred to as its intrinsic value. Cash flow is the ultimate driver of value and DCF is used to work out what the future cash flows of a company are worth in today’s money.
The good thing about this process is the discipline required to build a DCF also means they have asked several vital questions about the risks facing a business.
This could include things such as: competition; does it face the risk of higher taxes on its operations; and does it have large liabilities in the form of debt or pensions.
Most investors would not have the time or expertise to construct their own DCF model, but you can look closely at what you think might knock a business off course. You should also consider factors such as raw material costs and interest rates which could impact performance.
Intrinsic value is not the only factor determining the share price and it is important to consider how the stock is valued in the context of the wider market. There are several key metrics which can be used to measure relative valuation but the most familiar is probably the PE ratio.
In general terms the lower the PE, the cheaper the share - but initial appearances can be deceptive. Investors will gladly pay a high multiple if a firm has high margins, good earnings visibility or is growing rapidly.
You should look at a company’s PE relative to the market as a whole or its peer group. If a company trades at a discount to either of these benchmarks you need to ask if this discount is justified. This will depend on how its profit growth and other aspects of its financial performance compare to the market as a whole.
