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Applied Investment Research

"To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What is needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework." Warren E. Buffet

To provide this 'sound intellectual framework' is the objective of investment research.

Investment Research - A result oriented service

Investment Research can be defined very broadly as a process that contains one or more of the following:

Investment Research is useful to:

Process of Investment Research

Investment research involves fundamental analysis, technical analysis, or a combination of the two. Fundamental analysis essentially explains what to buy while technical analysis could be used to decide on when to buy.

• Fundamental Analysis
  
  Fundamental analysis begins with the assertion that the 'true' or 'intrinsic' value of any financial asset equals the present value of all cash flows that the owner of the asset expects to receive. Accordingly the fundamental stock analyst attempts to forecast the timing and size of these cash flows and then converts them into equivalent present value by using an appropriate discount rate . Once the true value of the asset is determined, it is compared with the current market price of the asset in order to see whether the asset is fairly priced. Those assets whose price is above the intrinsic value are said to be 'over valued' and those whose prices are lower than the intrinsic value are 'under valued'. The magnitude of the difference between the current market value and 'true value' is also important information, because the strength of the research conviction that whether a given asset is incorrectly priced will partly depend on this information. To determine the intrinsic value, the financial statements of a company are extensively analyzed. Other factors such as its credit rating, business model, competitor parity of the company are also thoroughly scrutinized.

• Technical Analysis
  
  Technical analysis involves the study of stock market prices of the financial asset under consideration, in an attempt to predict the future price movements it may take. Initially, past prices are examined in order to identify recurring trends or patterns in price movements. Then more recent prices are analyzed in order to identify emerging trends or patterns that are similar to past ones. This analysis is done in the belief that these trends or patterns repeat themselves. Thus by identifying an emerging trend or pattern, the analyst hopes to accurately predict future price movements for that particular asset.

• Combination Technique
  
  As can be seen, neither of the two methods is comprehensive. A synthesis of the two would be ideal rather than any one, giving the investor information on what to buy and when to buy it.

Apart from these two broad based techniques there are other techniques like passive investing which involves investing in index stocks or funds based on an active index.

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Methodology of Investment Research

Investment research is a scientific process that aims at finding out the value of an asset or group of assets with the help of certain factors. These factors are listed below.

• Earnings Quality
  
  Assessment of earnings quality plays an important role in the investment research process.
  
  In addition to extensive examination of a firm's operating history, analysts may employ proprietary measures. For example, S&P Core Earnings is a proprietary methodology that assesses a company's underlying economic earnings power by measuring earnings attributable to ongoing operations. Under this methodology, a company's period earnings performance includes only those revenues generated by the enterprise's stipulated commercial activities, and those direct and indirect expenses that were realized in the generation of those revenues.

• Top-Down & Technical Influences
  
  Top-down influences include macroeconomic forecasts , relative sector strength analysis, and capital market expectations. Important technical considerations may include analysis of a stock's intermediate-term trend and its relationship to key moving averages. Comparison with other stocks in the same industry also may lend insight as to whether a shift in price is related to the industry or to the individual security.

• Principal Valuation Methods
  
  Financial statement analysis is a core practice of investment analysts. It is integrated with intrinsic valuation techniques, principally via discounted cash flow (DCF) models that the analysts employ for each company covered. Assets, liabilities, and shareholder equity are evaluated to determine if the firm has sufficient resources to generate income and cash flow, as well as sufficient liquidity to ensure continuity as a going concern. Analysts also consider cash flow trends that enable them to understand how a company is generating and allocating capital.

• DCF Valuation
  
  DCF or discounted cash flow valuation is a key method to arrive at the intrinsic value of an asset.
  
  As a tool in the process of value discovery, analysts create and maintain spreadsheet models of both historical and projected financial statement items. These projected income statements, balance sheets, and cash flow statements are integrated with intrinsic value models for each company. Intrinsic value models attempt to determine the present value of projected cash flows. A principal method of intrinsic valuation is DCF modeling. Key inputs (explained below) include estimated cash flows, growth rates, and the discount rate. Like all intrinsic value techniques, DCF analysis is quite responsive to changes in inputs, so analysts employ sensitivity analysis to take into account a range of values and probabilities.

• Cash Flows
  
  The intrinsic value of any security is the present value of its expected future cash flows. Deriving intrinsic value is therefore a straightforward process when cash flows are known in advance with certainty, as is the case with non-callable, risk-free debt such as Treasury bonds. When future cash flows are not known with certainty, as is the case with corporate debt and equity, they must be estimated. Free cash flow to the firm (FCFF) is net cash flow from operating activities minus capital expenditures plus interest expense and sale of property, plant, and equipment. This figure represents cash flows to all providers of capital, bondholders as well as common and preferred shareholders, after taking into account net capital investments required for the ongoing enterprise.

• Growth Rates
  
  From the starting point of the most recent period's FCFF, the analyst estimates future growth rates to apply to those cash flows. Since DCF models are highly sensitive, providing quality growth rate estimates is a primary challenge. To accomplish this, it is the analyst's responsibility to gain insight into industry trends and individual company business drivers. For example, in capital-intensive industries, results may be driven primarily by cost structure, while for companies in emerging industries, future FCFF may depend on each company's product pipeline. Of course in the latter case, more estimation is required for valuation, which introduces additional uncertainty. Also, the sustainability of cash flows is heavily influenced by the competitive landscape. Important issues for consideration include the firm's tax and regulatory environment, the level of market saturation, the presence of barriers to entry or exit, historical returns on equity and assets, and the strategic plan (whether the firm is a high-margin or low-cost producer). The analyst's goal is to assign probabilities to various outcomes based on these considerations. These probabilities are used to arrive at growth rate assumptions for input into the DCF framework. A growing company will typically experience a temporary (perhaps several-year) period of above average growth. As the company and its markets mature, it is likely to revert to a growth rate roughly equivalent to that of the overall economy. In the DCF model, this is referred to as the "terminal growth rate." From that point on, future FCFF may be valued as perpetuity with a constant growth rate.

• Discount Rate
  
  Another input to determining the present value of future FCFF is the discount rate. When valuing projected cash flows to the firm, the weighted average cost of capital ( WACC) is typically used, although some practitioners prefer a risk free rate plus an equity risk premium. The main advantage of using WACC is that it takes into account the firm's cost of capital for common equity, preferred equity, and debt financing, as well as the capital structure of the balance sheet. The cost of equity is typically derived from the Capital Asset Pricing Model (CAPM), which requires some estimate of the firm's equity market beta. Since the historical beta may bear little relevance for the future, analysts are granted the flexibility to modify their estimates to allow for what they view as realistic assumptions of relative share price volatility going forward. The CAPM cost of debt is usually the yield at which outstanding debt trades or the risk free rate plus an appropriate credit spread.

• Combining the Inputs
  
  Once the future cash flows have been estimated, the discount rate is applied to arrive at the present value of the firm. The present values of debt and preferred stock are then deducted to obtain the present value of the firm's equity, its intrinsic value. If intrinsic value is well above current market capitalization, the stock would be deemed attractive from a DCF perspective. As noted before, DCF output is highly responsive to input. Because of compounding effects, small changes in growth estimates and discount rates have large effects on estimated value.

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• Relative Valuation
  
  Some industries do not lend themselves well to DCF analysis. For example, the value of companies in emerging industries depends largely on new products and those that may still be in development. In fact, many of these companies may not have a history of generating any FCFF. The biotechnology industry is an example. Other industries may generate profit from net margins (spread between assets and liabilities) and not operating activities. Banks and insurance companies are examples of this. In these situations other intrinsic value approaches may be applied, or analysts may also employ peer group analysis to measure a firm's value relative to its competitors. While the specific comparison metrics differ among industries, the principle remains that by comparing a firm to its peers on industry-relevant measures of performance, the analyst can determine its relative under- or over-valuation.

• Sum-of-the-Parts Valuation
  
  Sum-of-the-parts (SOP) valuation is generally utilized in special situations such as mergers and acquisitions, spin-offs, or analysis of conglomerates. SOP disaggregates a firm by its operating segments and derives a value for each. Each segment may be valued using DCF (if a segmented history of cash flows is available) or relative valuation (if good, stand-alone, comparables exist). Then the segment values are aggregated to estimate the overall value of the firm.

• Target Price
  
  A stock's target price per share represents the price that a given security is expected to trade in the future, normally in 12 months. In their determination of target prices, analysts consider intrinsic, relative, and SOP valuations if appropriate. They also keep in mind the likely micro- or macro-economic events that may emerge as catalysts for changes in earnings or multiples. To assess the probability of micro events occurring, analysts use their knowledge of the companies and industries they cover. For macro assessments, they rely on top-down indicators outlined above.

Outsource2india can also customize the Investment Research process depending on the asset class.

Benefits of Outsource2india's Investment Research methodology

O2I is a quality-driven, full-service business and market research firm. It presents business information and research services and believes in providing value to customers. Selecting and combining appropriate tools and methods to produce tailor-made solutions is the singular focus of our investment research team.

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