How to use equity research in your investing
Editorial staff, J.P. Morgan Wealth Management
- Equity research firms employ analysts who follow specific stocks and create reports to guide investors.
- An equity research report typically includes sections for investment thesis, valuation, risks, financial data and more.
- Most equity research reports will include metrics such as revenue, net income, free cash flow, earnings per share (EPS), price-to-earnings (P/E) ratio and others to validate the recommendations.
- Equity research often makes use of different types of analytical techniques when evaluating a stock.
Investing in the stock market has become a common method in the wealth-building process. Many people, especially if they are trying to build a nest egg for retirement, entrust this to a professional financial advisor. However, many investors like to manage their own portfolios. Of all the types of financial instruments that are available, stocks are a popular asset class for most people.
Before buying a stock, well-informed investors do research to evaluate the company to see if it should be added to their portfolio. Often, investors receive reports from a trusted equity research firm that conducts the research and evaluates the financial health of the company.
What’s in an equity research report?
Equity research firms will have their own methodology for presenting their analysis. That said, there is a general template that many such reports will follow:
- Investment thesis. Usually at the beginning of the report, an investment thesis will provide the reader with a brief outline of the company’s business focus. Additionally, it may also summarize any developments that the analyst deems important that could affect the stock’s performance.
- Valuation. In this section, the analyst states their recommendation for the stock. Usually, this will be a rating along with a numerical price target. A common ratings system in the investing arena is the overweight/neutral/underweight designation. This informs the reader of how the analyst views the stock’s prospects over a certain time frame, usually six to 12 months. The projected price target is the result of the calculations performed by the analyst.
- Risks. A staple of most credible equity research reports, this section should detail the potential drawbacks that could affect the stock’s expected performance.
- Summary of financial data. This section of the report will present pertinent financial data as evidence to support the analyst’s recommendations. This can be quite exhaustive, but there are a few metrics that are important to an investor and will be explained below.
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Important financial statements
Equity research reports glean information from three main financial statements to get as accurate a picture as possible into the company’s performance. These are:
- Balance sheet. This statement provides a snapshot of the financial health, or liquidity, of the company. It lists the company’s assets, liabilities (debt) and shareholder equity. Assets should equal, or “balance out,” the total of liabilities and shareholder equity. In other words, what the company owns (assets), what it owes (liabilities), and what is left to the shareholders if the assets were sold off and the liabilities paid off.
- Income statement. This shows how much money the company brought in from selling its products or services, and what it spent to provide those products and services. Basically, it answers the question: “Is the company making money?” Typically, an income statement is subdivided into three main sections – revenues, expenses and profits.
- Cash flow statement. As the name implies, this statement shows how much cash came in and out of the company in the reporting period. While this may sound similar to what is reported in the income statement, it is not. The difference is that the income statement is geared to show profitability, which can include non-cash figures for revenues and expenses. The cash flow statement, on the other hand, will show the company’s ability to generate cash from operating, investing and financing activities.
Pay attention to certain key metrics
Investors choosing to conduct their own research or check on the figures used in the equity research report may find the amount of data available on a company’s financial statements to be overwhelming. So, it might be helpful to narrow it down a bit. The following metrics are a few of the more popular ones used to evaluate a company, and most equity research reports will include these:
- Revenue. Found in the income statement and often referred to as the “top line,” this figure can be broken down into “operating” and “non-operating” revenue. Operating revenue is more useful, as it shows how much money is coming from the company’s core business. Basically, it is a reflection of how well the company’s business model is functioning.
- Net income (profit). This is the figure that is being referred to when someone speaks of a company’s “bottom line,” mainly because it is the final line item on the income statement. It is derived by subtracting operating expenses, taxes and depreciation from the “top line” figure. The higher the net income, the more attractive the company’s stock.
- Earnings per share (EPS). This takes the company’s earnings and divides it by the number of outstanding shares. It is useful because it allows the investor to compare the relative profitability of different companies. Actual EPS will be for the prior specified period, while forecasted EPS will be for the future specified period.
- Price to earnings ratio (P/E). This ratio is calculated by dividing the current stock price of the company by its EPS. There are both current and forecasted P/Es. This metric shows what investors are paying for a company’s current earnings and how much they are willing to pay for its expected earnings over the specified period, usually 12 months.
- Free cash flow. This shows the excess cash that the company generated over the specified period. It is derived by subtracting the company’s capital expenditures (CapEx), which are funds used for new projects or upgrading existing infrastructure, from the cash it generated from carrying out operating activities. This is useful because it allows the company to engage in actions that can add value to the shareholder, like increasing dividend payouts or doing stock buybacks.
- Dividends per share (DPS). Dividends are periodic payments made to the shareholder, usually from a company’s profits. A company paying dividends at regular intervals at an increasing rate is quite attractive to an investor seeking a stable income stream.
Other things to keep in mind when analyzing stocks
Warren Buffett’s reputation as a legendary investor has been built upon an impressive track record that has stood the test of time. His “secret” is to invest in stocks that have value.
A popular quote of his is, “Price is what you pay, value is what you get.” One interpretation of this is that one must use qualitative as well as quantitative analysis when evaluating a stock. In other words, investors want to find answers to questions like:
- Do you understand how the company makes money?
- Is there an advantage this company has over its competitors that is hard to overcome?
- How effective is the company’s management?
This sort of analysis will also help an investor determine if the company is the right fit for their portfolio and investment goals.
The bottom line
Equity research reports can help you decide whether a stock fits your investing goals by outlining the thesis, valuation and risks of the stock and providing supporting metrics like revenue, EPS, P/E and cash flow.
You may also pair the research report analysis with a simple check – do you understand how the business makes money and does it fit into your investing plan – to help decide whether to add the stock to your portfolio.
If you want support, consider working with a financial advisor who can help you evaluate opportunities and keep your investments aligned with your objectives.
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Editorial staff, J.P. Morgan Wealth Management
