Key Equity Research Approaches to Know

Some of the equity research approaches are top-down approaches, discounted cash flow models, bottom-up approaches, and free cash flow models.

An equity analyst tries to identify undervalued or overvalued stocks by combining his expertise and the tools. Securities must be valued appropriately to make the right investment decisions.

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Taking a top-down approach: Top-down forecasting uses macroeconomic projections to predict returns for large stock market composites, such as SENSEX, NIFTY, and S&P 500. As a result, return expectations can be further refined for various market sectors and industry groups within the composites. As a final step, such information can be distilled into projected returns for individual securities if desired. Top-down approaches aim to understand the big picture, i.e., the most significant trends. On the basis of these insights, analysts develop their forecasts. As a result, they can determine the "right" asset allocation (bonds, real estate, equities, etc.) as well as market, sector, and company selection.

Top-down analysts use economic information to analyze sector-specific and technical aspects of stock market developments. As an example, this information includes growth prospects for individual economies (GDP growth), inflation and deflation, unemployment, foreign trade developments, consumer sentiment, oil price movements, volatility in the stock market, and leading indices such as small and midcap or sector indices.

Models of discounted cash flows: Discounted cash flow model assumes that a business is worth the present value of its future cash flows. This is the after-tax cash flow available to shareholders for the rest of their lives. To calculate the after-tax cash flows available to shareholders, an analyst must calculate the revenues generated by the business and deduct all the cash-based expenses that are incurred to generate those revenues, including taxes and capital expenditures. In order to determine the present value of cash flows, DCF analysis uses two pieces of information.

Estimated future cash flows.

The discount rate assesses the potential variability of those cash flows.

DCF analysis assumes that cash flows today and in the near future are worth more than cash flows in the future. The discount rate determines how much more there will be. The higher the discount rate, the more variable the cash flows, and the less value they have in the future. The enterprise value of a company can be defined as the total present value of all future cash flows, including debt and equity.

In order to calculate shareholder equity, the Net debt must be subtracted from Enterprise Value. Net debt is long-term borrowings, i.e., bank debt, less cash, or equivalents. It is fine if the company has more cash than long-term borrowings; Net debt is negative and therefore adds to enterprise value. Dividing the value of shareholders' equity by the number of outstanding shares to determine a value per share is necessary.

Taking a bottom-up approach: In bottom-up forecasting, the fundamentals of individual companies are analyzed first. It is possible to aggregate the forecasts for individual security returns into expected returns for industry groups, market sectors, and equity markets as a whole. A purely bottom-up approach does not consider analyzing and forecasting "macro-events" and constructing logical chains of reasoning. A systematic bottom-up investor focuses on individual investment objects rather than the macro-environment.

An analysis of individual companies is based on concrete and, as a rule, predefined criteria. Each share in the portfolio meets all of these criteria. Among these criteria are key financial figures, growth forecasts, dividend payments, qualitative aspects, international focus, size, management stability, ownership structure, etc.

Models of free cash flow: The free cash flow (FCF) of a company represents its ability to generate cash after spending the money needed to maintain or expand its asset base. A measure of financial performance is calculated by subtracting capital expenditures from operating cash flow.

A company's free cash flow allows it to pursue opportunities that enhance shareholders' value. Developing new products, making acquisitions, paying dividends, and reducing debt is difficult without cash.