What Is Equity Research & How to Do This?

What to expect?

Now we will learn how to do equity research. Remember that when a common man like us and you do equity research, he has to do this work with limited resources. The only tools we have for conducting equity research are the Internet, company annual reports, and Microsoft Excel. When a company or organization does this equity research, it has a different person for this work, it gets an opportunity to talk to the management of the company, there are many types of financial data like industry reports, etc. It buys money from Bloomberg, Reuters or any other such company. So we will try to know that how to do this work in the best possible way with our limited resources and can make a good decision to buy the shares of a company.

We will divide equity research into three distinct phases.

  • understanding business
  • check by checklist
  • Valuation of the company to determine the true value of the share

Each of these phases will have a number of steps that we will have to take. There is no shortcut for this.

Share Price vs Business Health

Whichever company you choose for research, first of all, the better you can understand the business of that company. Most people get directly involved in the analysis of a company’s stock price. If you go straight into the analysis of stock prices from a short-term perspective, then that is fine, but it is very important to understand the business of the company from the long-term perspective.

You must be thinking that why is this so important? The reason is very clear, if you know about the business of the company well, then you will not worry about the price of the stock in the bear market. Remember that in a bearish market the price changes, or perhaps reacts, not the core business of the company. If you know and understand the company and its business, you will have a solid reason to stay in the stock even in a falling market. It is said that there are opportunities to buy shares in the bear market, so if you know about the company well, you have faith in the basic business of the company, then you will buy more stocks and not sell them in the falling market. It is important to mention here that it can take a long time to implement this approach properly.

Well, the best source to get information related to the business of any company is the company’s website and its annual report. We should read the annual report for at least the last 5 years, to understand how the company has evolved in different business cycles.

Understanding the Business

To understand business, we have to first make a list or list of some questions, for which we have to find the answer. Note that the answers to all these questions will be found on the company’s website and in the annual report.

Below is a list of questions that will help us understand the business. I have also explained the logic behind each question.

No Question logic of question
1 What does the company do? To understand the condition of the business
2 Who are the promoters of the company and what is their background? To find out if there is a criminal record, there is no political connection
3 What does the company manufacture? (If there is a manufacturing company) Knowing the product of the company, to know that how much is the demand in the market and how much is the supply?
4 How many factories does the company have and where are they? This shows where the company is located. Also, if the company’s factories are located in very expensive areas, then their value may not show on the balance sheet, but it is information that makes the company very valuable.
5 Are all factories operating with full production capacity?
Finds out the capacity of the work, it also comes to know whether the company will be able to meet it when the demand increases or not
6 What kind of raw material is needed for production?
If the government does not control the raw material of the company, the raw material of the company does not have to be imported? This may affect the business of the company.
7 Who buys the company’s goods, or who are the company’s clients?
This shows the business cycle of the company, it also shows how difficult it is to sell the goods.
8 Who are the rivals of the company?
If there are multiple rivals, the margins of the company can be affected. If there are less then the margins of the company can be maintained for a long time.
9 Who are the important shareholders of the company?
If some big and successful investors have invested in the company then it is a good sign.
10 Is the company about to launch a new product?
This shows the intention and willingness of the company to innovate. If the company is bringing a new product out of its area of ​​expertise, then the focus of the company may be questioned.
11 Does the company have plans to expand overseas?
This shows the intention and willingness of the company to innovate. If the company is bringing a new product out of its area of ​​expertise, then the focus of the company may be questioned.
12 What is the revenue mix of the company? Which product sells the most? Finds out from which product the company is earning the most. This gives an idea of ​​the future of the company.
13 Is the company in a heavily controlled business?
This can be good as well as bad. More control means a new opponent cannot come easily. But too much control reduces the company’s ability to innovate.
14 Who are their bankers and auditors?
This gives an idea of ​​how likely the company is to go wrong.
15 How many employees are there in the company? Is there any problem related to workers and employees in the company? It shows how dependent the company is on the employees and their skills. If employees of certain skills are needed, it can become a threat to the company.
16 What are the barriers or impediments in the entry of new players in the industry?
Find out how easy or difficult it is to get a new competitor in front of the company
17 Can the company’s product be made very easily in other countries, where labor is cheap?
If yes, then the company may be in trouble anytime
18 Does the company have multiple subsidiaries?  If yes, then the question is whether it is needed or not? Somewhere the company has not done this to mingle money?

Through these questions, you will be able to understand about the company. While asking these questions and searching for their answers, many more new questions will come in your mind, for which you will have to find the answer. If you will be able to find the answer to them correctly, then now you will be able to know the company better. Remember this is the first stage of equity research, if you see danger signs at this stage then there is no need to work on that company no matter how attractive the company may seem.

I can tell from my experience that the first phase of equity research of any one company takes at least 15 hours. After that I write down all the important things on one page. This information should be very well thought out and focused. If you are not able to do this, then assume that you do not have complete information about the company yet. It is only after the first phase is completed that I move on to the second phase of equity research.

Now we will move on to the second phase of equity research. The best way to understand this is to check any one company on the basis of our checklist.

We have talked about Amara Raja battery earlier, it would be better if we put our check list on the same company and check it out. You can check that company by putting this check list of any company.

Just remember that we are here trying to understand that further discussion and discussion will be around ARBL, so that we can understand this company better. Whether the company is good or bad, it is not the issue here, but to make you aware of the framework through which you can complete the process of equity research in a proper way.

Use of the Checklist

The first step of equity research helps us to understand the how, what, who and why of any business. In this way, we will be able to create a holistic approach taking into account every aspect of the company. But after this, as much as the business seems to be attractive, the numbers of the business should also look equally attractive.

The objective of Phase II of Equity Research is to help us understand the numbers and assess whether the way a company operates and its financial performance complement each other. If these are not complementary to each other then we will assume that the company does not have the qualities required to invest in it.

We looked at the checklist in the previous chapter. see him once again.

No. which figure description meaning
1 Increase in Net Profit
matching total or gross profit Increases with Profit even in matching income with Gross Profit
2 EPS EPS should increase with net profit If the company is increasing its equity shares then it is not good for the shareholders.
3 Gross profit margin (GPM) > 20% Higher margin indicates that the company has a significant gap
4 Level of debt The company should not be in debt.
High debt means that the company is not in good shape. Finance cost will also be high and this will reduce the earnings of the company.
5 Inventery for manufacturing companies The simultaneous increase in inventory and PAT is a good sign for companies doing inventory manufacturing. Must Check Inventory Number of Days
6 Sales vs Recievables Growing sales through receivables is not good,
it shows that the company is forcefully increasing sales just to show earnings
7 Operations cash flow The cash flow from the operation should be positive. If cash is not coming from the operation of the company, then it is a sign of pressure on the operation.
8 Return on equity >25% ROE, higher the better for the investor but check the level of debt

Now we will go through all the points in the checklist with reference to Amara Raja Batteries Ltd. First let’s look at the P&L items – Gross Profit, Net Profit and EPS of the company

Revenue & PAT Growth

The first sign of the firmness of any company to be investible is that that company is growing, that is, it is growing. Growing here means that the company’s income is increasing and its PAT is also increasing. We look at this from two perspectives –

Year on Year Growth– This tells us how much growth is happening in the company every year. Sometimes the company is not able to grow even because of a business cycle. So you have to see how the company is growing. Sometimes the growth of the company is very less or does not grow year after year. In such a situation, you must check that in what way the rest of the company’s rivals or industry is growing, if there is a similar increase, then the growth of the company will be considered correct.

Compounded Annual Growth Rate (CAGR) – This tells us whether the company is growing even though the business cycle is down. A growing company is considered one of the best companies to invest in despite the downturn in the business cycle. This increase is reflected in the CAGR.

Personally, I prefer to invest in companies whose earnings and PAT grow at 15% CAGR.

Take a look at how ARBL is doing…

FY 09 -10 FY 10-11 FY 11-12 FY 12 -13 FY 13 – 14
Revenue/ Income (crores) 1481 1769 2392 3005 3482
Revenue Growth 19.4% 35.3% 25.6% 15.9%
PAT (Crores) 167 148 215 287 367
PAT growth (11.3%) 45.2% 33.3% 27.8

There is a CAGR of 18.6% in 5-year earnings and a CAGR of 17.01% in 5-year PAT. These figures are looking very good. But we have to check these on other parameters of our check list as well.

Earnings Per Share (EPS)

Earnings per share or Earnings per share tells us how much profit the company is making on each share. If the EPS and PAT are increasing at the same rate, it means that the company has not increased its number of shares which is a good thing. This shows that the management of the company is good.

FV Rs.1 FY 09 -10 FY 10-11 FY 11-12 FY 12 -13 FY 13 – 14
EPS (INR) 19.56 17.34 12.59 16.78 21.51
Share capital 17.08 17.08 17.08 17.08 17.08
EPS growth   – -11.35%  – 27.39% 33.28% 28.18%

5 year EPS growing at 1.90% CAGR.

Gross Profit Margins

Gross profit margin is always shown in percentage. The formula to extract it is

Gross Profit / Net Sales

Here Gross Profit = Net Sales – Cost of Goods Sold – Cost of Finished Goods

Gross Profits = [Net Sales – Cost of Goods Sold]

Basically, the cost of finished goods is the amount spent on making the company’s products. We saw the way to calculate this while working out the Inventory Turnover Ratio. Let us see how the gross profit margin of ARBL has been.

In crores FY 09-10 FY 10-11 FY 11-12 FY 12 -13 FY 13 – 14
Net sales 1464 1757 2359 2944 3404
COGS 1014 1266 1682 2159 2450
Gross profit 450 491 677 785 954
Gross profit margin 30.7% 27.9% 28.7% 26.7% 28.0%

The gross profit margin of the company is looking very good here. According to our checklist, the gross profit margin of the company should be at least 20%. ARBL’s gross profit margin is much higher than this. it means that

ARBL’s rivals are very low, hence the company’s margins are quite high.

The company is doing very well and the management is also working very well due to which the margin of the company is high.

Debt level – Balance Sheet check

The first three points of the checklist were linked to the company’s profit and loss statement. Now we will look at such points which are linked to the balance sheet. One of the most important things to look for in a balance sheet is a company’s debt. The higher it is, the more difficult it will be for the company. This can be dangerous if a company is taking on more debt for its growth. Higher debt means that the finance cost of the company will be very high, which will reduce the retained earnings of the company.

ARBL loan

Debt 91.19 95.04 84.07 87.17 84.28
EBIT 261 223 321 431 541
Debt/EBIT (%) 35% 42.61% 26.19% 20.22% 15.57%

The debt of the company is around 85 crores. The good thing is that the debt of the company has come down as compared to 2009-10. After checking the interest coverage ratio, I personally want to check the debt of the company as a percentage of Earnings Before Interest and Taxes (EBIT). This shows how well the company handles its financial condition. We can see that the debt/ EBIT of the company is decreasing continuously which means that ARBL has done well in this matter.

Inventory Check

Inventory data should be checked if the company is manufacturing i.e. making products. This tells us several things:

Increase in inventory and increase in PAT indicates that the company is growing
A stable Inventory Number of Days tells us that the company is running its business properly.

Let’s look at ARBL’s inventory data

FY 09-10 FY 10-11 FY 11-12 FY 12 -13 FY 13 – 14
Inventory (crores) 217.6 284.7 266.6 292.9 335.0
Inventory days 68 72 60 47 47
PAT (crores) 167 148 215 287 367

The inventory number of days of the company is stable. In fact it is going down a bit as well. We learned in the previous chapter to calculate the Inventory Number of Days. Company Inventory and PAT are increasing together which is a good sign.

Sales vs Receivables

Now we will look at the sales figures of the company. These data will be viewed along with the receivables. If the sales of the company is increasing along with the receivables, then it is not a good sign. This means that the company is selling its goods on credit and due to which many questions may arise. Are the employees of the company forcibly selling the goods? Is the company giving credit for free somewhere?

FY 09-10 FY 10-11 FY 11-12 FY 12-13 FY 13-14
Total sales 1464 1758 2360 2944 3403
Receivables 242.3 305.7 319.7 380.7 452.6
Receivables % 16.5% 17.4% 13.5% 12.9% 13.3%

This figure of the company also seems to be stable. A look at the chart above shows that most of the company’s sales are not due to receivables. In fact, like inventory number of days, receivables as a percentage of net sales are also falling which is a good thing.

Cash or Cash Flow from Business Cash flow from Operations

One of the most important things to look for while investing in a company is the cash flow from the operations. The company should generate good cash flow from its operations. The company which is losing cash in its operations is in very bad shape.

Rs. Crores FY 09-10 FY 10-11 FY 11-12 FY 12-13 FY 13-14
Operation cash flow 214.2 86.1 298.4 335.4 278.7

The cash flow here seems to be going up and down a bit, yet it has remained positive for the last 5 years. This means the business of the company is going well and is generating cash i.e. the company is successful.

Return on Equity- ROE

We have talked about Return on Equity in detail in Chapter 9 of this module. I would like you to read it once again. ROE tells what percentage of profit the company has made in terms of shareholders. In a way, it tells how much the promoters have earned by investing their money.

The ROE of ABRL for the last five years is shown below-

Rs. Crores FY 09-10 FY 10-11 FY 11-12 FY 12-13 FY 13-14
PAT 167 148 215 287 367
Shareholder equity 543.6 645.7 823.5 1059.8 1362.7
ROE 30.7% 22.9% 26.1% 27.1% 27.0%

The ROE numbers given above are quite good. I myself prefer to invest in companies whose ROE is above 20%.

Conclusion

Remember we are in the second stage of equity research. ARBL has met all the criteria required in the second phase. Now as an Equity Research Analyst, you have to look at the output of Phase II in the context of the information gathered in Phase I. After both the steps, if you are able to form a positive opinion about the company based on the facts, then the company has the qualities that make it worth investing in.

However, before buying the stock, check that the price is correct. And that’s what we do in Phase III of Equity Research.

Highlights of this chapter

  • Equity Research “Limited Resource” can be done in 3 steps
  • understanding business
  • from the checklist app
  • valuation
  • The purpose of the first phase is to understand the business of the company and gather the necessary information for it. And the best way for this is the Q&A method, that is, the question-and-answer method.
  • In the Q&A approach, we start with simple and clear questions and look for answers.
  • By the end of the first phase, we should have all the business related information.
  • Most of the answers we seek in the first phase will be found on the company’s annual report and website.
    In the first stage itself, if you ever doubt any information, or if you are not sure, then it would be better to
  • stop the research there.
  • In the first step, it is very important that you have a strong belief in the company from the information you have gathered. This confidence will give you a reason to stay in the stock during a downturn.
  • In the second phase of equity research, you have to examine the performance of the company on different parameters.
  • And it is obvious that only after completing the first two steps will you be able to move towards the third stage. ‌