Traditionally, lip sympathy was paid to equity research. Financial institutions (mutual funds, in particular) had a research cell because it was in good form to have one. Likewise, large brokers set up equity research cells to satisfy their institutional clients. In the mid-1980s more progressive firms like Enam Financial, DSP Financial Consultants, and Motilal Oswal Securities Limited set up research division to exploit the opportunities in the equity market. With the entry of foreign institutional investors and the emergence of more discerning investors, the need for equity research is felt more widely. First time foreign funds and stock brokers investing in India want to know more about Indian business and depend on Indian researchers who are more familiar with the local environment. Indeed currently equity research is a growing area.
Equity researchers who are able to do their job well have bright prospects. The future belongs to those who will:
1. Have a clear understanding of what their research is supposed to do and how they should go about doing it.
2. Learn to interpret financial numbers and assess qualitative factors which may not be immediately reflected in numbers.
3. Develop a medium term or long term perspective based on an incisive understanding of the dynamics of the companies analyzed.
Obstacles in the way of an analyst:
There are three main obstacles in the way of successful fundamental analysis:
1. Inadequacies or incorrectness of data
2. Future uncertainties
3. Irrational market behavior
Inadequacies or incorrectness of Data: An analyst has to often wrestle with inadequate or incorrect data. While deliberate falsification of data may be rare, subtle misrepresentation and concealment are common. Often, an experienced and skilled analyst may be able to detect such ploys and cope up with them. However in some instances he too is likely to be misled by them into drawing wrong conclusions.
Future Uncertainties: Future changes are largely unpredictable; more so when the economic and business environment is buffeted by frequent winds of change. In an environment characterized by discontinuities the past record is a poor guide to future performance.
Irrational Market Behavior: The market itself presents a major obstacle to the analyst. On account of neglect or prejudice, under-valuations may persist for extended periods likewise, over-valuations arising from unjustified optimism and misplaced enthusiasm may endure for unreasonable lengths of time. The slow correction of under or over-valuation poses a threat to the analyst. Before the market eventually reflects the values established by the analysts, new forces may emerge. The particular danger to the analyst is, that because of such delay, new determining factors may supervene before the market price adjust itself to the value.
The two principal methods of equity valuation are the divided discount method and the earnings multiplier method.
In practice, the earnings multiplier method is the most popular method. The key questions to be addressed in the earnings multiplier method are: What is the expected EPS for the forthcoming year? What is reasonable PE ratio given the growth prospects, risk exposure and other characteristics of the firm? To answer these questions, the investment analyst starts with a historical analysis of earnings (and dividends), growth risk, and valuation and uses this as a foundation for developing the forecasts required for estimating he intrinsic value.
To assess the earnings and dividend level, investment analysts look at metrics like the return on equity, the book value per share, the EPS, the dividend payout ratio, and the dividend per share.
The return on equity (ROE), perhaps the most important metric of financial performance is decomposed in two ways for analytical purposes.
The most commonly used valuation multiplies are: price to earnings (PE) ratio and price to book value ratio.
Analysis of financial statistics must be supplemented with an appraisal mostly of a qualitative nature of the company’s present situation and prospects and the quality of its management.
The procedure commonly employed by investment analysts to estimate the intrinsic value of a share consists of the following steps: (1) Estimate the expected EPS. (2) Establish a PE ratio, (3) Develop a value anchor and the value range.
Since valuation is inherently an uncertain and imprecise exercise, practical wisdom calls for defining an intrinsic value range the value anchor.
There are three main obstacles in the way of successful fundamental analysis: inadequacies or incorrectness of data; future uncertainties and irrational market behavior.