Learning Module 11 of Equities 11–14% of the exam

Equity Research Reports

3 lessons. About 17 minutes in cram mode, 80 minutes in full.

Start with lesson 1 Learn with Sensei Read the module summary Practice this module

Lessons

1
Equity research reports: contents, ratings and price targets
describe 6 min cram, 26 min full
2
Sell-side, buy-side and activist short-seller research
compare 5 min cram, 24 min full
3
Why two analysts using the same model get different values
explain 6 min cram, 30 min full

What the exam expects you to do

Describe the elements that should be covered in a detailed company research report.Equity research reports: contents, ratings and price targets
Compare sell-side and buy-side equity analyst reports and their conclusions.Sell-side, buy-side and activist short-seller research
Explain why value estimates from the same modeling approach may differ based on analyst assumptions regarding revenue, profitability, investment, and financing.Why two analysts using the same model get different values

Module summary

The whole module on one sheet, organised by lesson: what to memorize, how the ideas fit together, the formulas and the key terms. No paragraphs, just what you need to revise.

Hide what I know

How deeply to learn each part

Know the idea: Understand it in general. It frames other topics, but you will not calculate with it.
Use it: Understand it well enough to solve a question with it. Recognize when it applies.
Memorize: Learn it by heart. The exam will not give it to you.

Equity research reports: contents, ratings and price targets

Known

MemorizeWhat sits where in a research report

Section	Holds
Opinion and summary (first page)	rating, price target and horizon, implied return, thesis, catalysts, ticker, sector, market capitalization, market float, earnings summary
Business, industry, competition	business model, products, suppliers and customers, peers, the forces that matter
Financial analysis and valuation	key ratios only (including industry ratios), more than one valuation approach
Investment risks	company, industry, macroeconomic; scenarios built into the valuation
Sustainability	environmental, social and governance strengths and controversies; detailed where financially material

Memory hook Call, Company, Cash, Caution, Climate: the five sections in reading order.

Know it cold Written last: the first page. Thesis = why mispriced; catalyst = what closes the gap.

MemorizeFrom target to rating

Rating	Rule of thumb
Buy / overweight	at least about +10%-15% (absolute, or above the benchmark)
Hold / neutral	in between
Sell / underweight	at least about 10%-15% below zero or below the benchmark

Memory hook Relative = subtract the benchmark first.

Know it cold Expected appreciation = (target − price) ÷ price; no uniform standard; horizon usually one or two years.

Key terms

equity research report Know the idea
initiating coverage Know the idea
periodic report Know the idea
absolute rating Use it
relative rating Use it
expected appreciation Use it
price target Memorize
investment thesis Memorize
catalysts Memorize
market float Memorize
peer group Know the idea
available seat kilometers Know the idea
transitory risk factor Know the idea
sustainability section Know the idea

The sections of an equity research report

Equity research reportwritten to persuade; summary first, written last

Opinion and investment summary Memorize the first page
- Price target point or range, usually one year
- Investment thesis why the stock is mispriced
- Catalysts events that could close the gap
- First-page data ticker, sector, market capitalization, market float, recent news, earnings
Business, industry and competitive position Memorize business model, peers, the forces that matter
Financial analysis and valuation Memorize key ratios only; more than one valuation approach
Investment risks Memorize company, industry, economy; built into the valuation
Sustainability and other factors Know the idea depth depends on jurisdiction and industry

When reports are written

Research report

Initiating coverage Use it first report, often after an initial public offering; thorough
Periodic report Use it after an event or an expected announcement
- Episodic event a merger or acquisition
- Expected announcement quarterly earnings

Investment risks by source

Investment risks

Company-specific Use it one product or client, operations, strategy
Industry-wide Use it cycles, new entrants, regulation
Macroeconomic Use it inflation, interest rates, exchange rates

Formulas

Expected appreciation to the price target Memorize

\text{Expected appreciation} = \dfrac{\text{Target price} - \text{Current price}}{\text{Current price}}

Quick example

A share trades at 2,500 Japanese yen and the one-year target is 2,900 yen. (2,900 − 2,500) ÷ 2,500 = 400 ÷ 2,500 = 16.0%.

On your calculator

2900−2500=÷2500= 0.16

2900ENTER2500−2500÷ 0.16

ENTER enter (on the HP, puts the number on the stack)

Sell-side, buy-side and activist short-seller research

Known

MemorizeSell side vs buy side

	Sell side	Buy side
Audience	external clients	internal teams, portfolio managers
Depth	broad, standardized	in depth, strategy-focused
Models	accepted (discounted cash flow, multiples), earnings focus	may be proprietary
Detail	general	customized
Regulation	restricted: separated from banking, no material nonpublic information, limits around offerings, second Markets in Financial Instruments Directive (MiFID II)	largely unconstrained
Ratings	sells are rare	any

Memory hook Sell side sells research to clients, so it is public and policed; buy side buys stocks for itself, so it is private and free.

Know it cold Activist short sellers: buy-side research made public, after the limited partners.

MemorizeScreens and the effective report

Item	Remember
Screen steps	universe → primary criteria → secondary metrics → refine
Screen purpose	focus research on stocks that fit the strategy (shrinks the universe)
Screen drawback	arbitrary thresholds drop good candidates; fix: rank ordering with weights
Effective report	timely, clear, objective, facts vs opinions, consistent, critiquable, risks, conflicts disclosed

Memory hook Eight marks of a good report: Time, Talk, Truth, Tell facts, Tie together, Testable, Threats, Ties disclosed.

Know it cold Sell ratings are rare because of banking ties, management access and negative sentiment.

Key terms

sell-side research report Memorize
buy-side research report Memorize
material nonpublic information Use it
research unbundling Memorize
research as a cost center Know the idea
consensus Know the idea
contrarian view Know the idea
stock screening Use it
rank ordering Use it
activist short seller Use it
limited partners Know the idea

Who writes equity research

Equity research

Sell side Memorize banks and brokers; published for clients
- Initiating coverage and periodic reports standardized
- Consensus aggregated forecasts
Buy side Memorize asset managers; confidential
- Investment committee reports decide and monitor
- Activist short sellers Use it publish after limited partners

The four steps of a stock screen

Stock screenfrom a universe to a researchable few

1. Universe Use it for example an index
2. Primary criteria Use it fit the strategy
3. Secondary metrics Use it sharpen the fit
4. Refine Use it until each survivor can be researched

Why two analysts using the same model get different values

Known

MemorizeRevenue and margin against value

	Margin up	Margin down	Margin flat
Revenue up	value up more	value up less, maybe down	value up equally
Revenue down	value down less, maybe up	value down more	value down equally
Revenue flat	up	down	none

Memory hook Same direction = amplify; opposite directions = it depends on the size.

Know it cold Three main sources of different targets: revenue growth, profitability, terminal value. Financing should not create much value.

MemorizeInvestment, growth and the price

Item	Remember
Investment faster than income	free cash flow down; reinvestment up; return on capital down
Investment slower than income	free cash flow up; reinvestment down; return on capital up
FCFE	net income − net investment + net debt issued
Long-run growth	(net investment − net debt issued) ÷ net income × return on equity
Implied $g_l$	$r_e$ − forward FCFE yield at the horizon

Memory hook No growth without investment: revenue up with investment flat is too good to be true.

Know it cold Same prospects, lower implied growth in the price = better value.

Key terms

hard to value Know the idea
terminal value Memorize
implied long-run growth rate Use it
forward FCFE yield Use it
equity reinvestment rate Use it
long-run FCFE growth Use it
divergence of opinion Know the idea

Why value estimates differ

Different values, same model

Revenue growth Memorize over the forecast horizon
Profitability Memorize margin changes
Terminal value Memorize long-run growth and the horizon
Investment Use it must match the growth
Financing Use it should not create much value

Formulas

Two-stage FCFE value with price set equal to value Use it

P_t = IV_t = \sum_{i=1}^{n} \dfrac{\text{FCFE}_{t+i}}{(1 + r_e)^i} + \dfrac{\text{FCFE}_{t+n+1} / (r_e - g_l)}{(1 + r_e)^n}

Quick example

Free cash flow to equity (FCFE) of 150, 260 and 380 over three years, 450 in year 4, cost of equity 10% and long-run growth 5%. 636.74 + (450 ÷ 0.05) ÷ 1.331 = 636.74 + 6,761.83 = 7,398.57.

On your calculator

CF2NDCLR WORK
0ENTER↓150ENTER↓↓260ENTER↓↓380ENTER
NPV10ENTER↓CPTSTO2 636.74
2NDQUIT
1.1y^x3=STO1 1.331
450÷0.05÷RCL1+RCL2= 7,398.57

CF cash flow worksheet · 2ND second function (the shifted label above a key) · CLR WORK clear the worksheet · ENTER enter (on the HP, puts the number on the stack) · NPV net present value · CPT compute · STO store · QUIT leave the worksheet · y^x power · RCL recall a stored number

fCLEAR REG
0gCF0150gCFj260gCFj380gCFj
10ifNPV 636.74
450ENTER0.05÷1.1ENTER3y^x÷+ 7,398.57

f gold shift key · CLEAR REG clear all registers · g blue shift key · CF0 cash flow at time zero · CFj cash flow j · i interest rate per period · NPV net present value · ENTER enter (on the HP, puts the number on the stack) · y^x power

Implied long-run growth rate Use it

g_l = r_e - \dfrac{\text{FCFE}_{t+n+1}}{(1 + r_e)^n \left[ P_t - \sum_{i=1}^{n} \dfrac{\text{FCFE}_{t+i}}{(1 + r_e)^i} \right]}

Quick example

Market value 2,000, cost of equity 9%, FCFE of 60 and 80 in years 1 and 2, 95 in year 3. (2,000 − 122.38) × 1.09² = 2,230.80; yield 95 ÷ 2,230.80 = 4.26%; g_l = 9% − 4.26% = 4.74%.

On your calculator

CF2NDCLR WORK
0ENTER↓60ENTER↓↓80ENTER
NPV9ENTER↓CPTSTO2 122.38
2NDQUIT
1.09y^x2=STO1 1.1881
2000−RCL2=×RCL1= 2,230.80
1/x×95= 0.0426
+|-+0.09= 0.0474

fCLEAR REG
0gCF060gCFj80gCFj
9ifNPV 122.38
CHS2000+ 1,877.62
1.09ENTER2y^x× 2,230.80
1/x95× 0.0426
CHS0.09+ 0.0474

f gold shift key · CLEAR REG clear all registers · g blue shift key · CF0 cash flow at time zero · CFj cash flow j · i interest rate per period · NPV net present value · CHS change sign · ENTER enter (on the HP, puts the number on the stack) · y^x power · 1/x reciprocal

FCFE from net income Memorize

\text{FCFE} = \text{Net income} - \text{Net investment} + \text{Net debt issued}

Quick example

Net income 540, net investment 150, net debt issued 60. 540 − 150 + 60 = 450.

On your calculator

540−150+60= 450

540ENTER150−60+ 450

ENTER enter (on the HP, puts the number on the stack)

Equity reinvestment rate Memorize

\text{Equity reinvestment rate} = \dfrac{\text{Net investment} - \text{Net debt issued}}{\text{Net income}} = 1 - \dfrac{\text{FCFE}}{\text{Net income}}

Quick example

Net income 540, net investment 150, net debt issued 60. (150 − 60) ÷ 540 = 16.67%, the same as 1 − 450 ÷ 540.

On your calculator

150−60=÷540= 0.1667

150ENTER60−540÷ 0.1667

ENTER enter (on the HP, puts the number on the stack)

Long-run FCFE growth Memorize

\text{Long-run FCFE growth} = \text{Equity reinvestment rate} \times \text{ROE}

Quick example

Net income 200, net investment 130, net debt issued 30, return on equity (ROE) 14%. Reinvestment rate (130 − 30) ÷ 200 = 50%, and 50% × 14% = 7.0%.

On your calculator

130−30=÷200=×0.14= 0.07

130ENTER30−200÷0.14× 0.07

ENTER enter (on the HP, puts the number on the stack)