Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.
Decoding broker research
Equity analysts are employed by investment banks and stockbrokers to research companies and provide investment ideas to their clients. Their work is not always freely available to the public but snippets do regularly appear in the financial press. These can provide an insight into the market’s opinion on a company and provide a useful basis for further research. But first you need to understand what all the elements of an analyst’s research mean.
Rating and slating
Analyst’s ratings fall into two categories, in general.
First is ‘buy, sell or hold’. When you see price targets alongside buy, sell or hold recommendations - the broker believes the shares will hit that level within the next 12 months. Those price targets are used to determine the share price recommendation.
A buy tends to be when a broker believes the share price will rise by more than 10% from the current price over the next 12 months. A hold is when they believe the share price will either rise by less than 10%, or fall by less than 10%, versus current price. Sell is when they think the shares will fall by more than 10% versus the current price. The rules are subjective and vary from broker to broker in terms of the exact percentages used. You might also see ‘neutral’ - which is essentially the same as ‘hold’.
Weighting it up
The second method is to rate a stock using ‘overweight, equal weight and underweight’. This is comparing the predicted share price performance of a company relative to its sector.
For example Engineer X might have an ‘overweight’ rating if the broker thinks it will materially outperform the broader engineering sector.
‘Corporate’ is used when a so-called ‘house’ broker has a policy of not using a ‘buy, sell or hold’ rating. A house broker is appointed by the company to help drum up interest in the stock. As such their view is not independent, and may show some bias towards their client.
Some house brokers take the view that it would be inappropriate for them to have a ‘buy, sell or hold’ rating on a company who is also paying them for broking services. The ‘Corporate’ rating is used on research notes instead of ‘buy, sell or hold’.
The price is right
Most price targets are based on a one-year time horizon. These predictions have had at best a varying degree of success. A 2012 global study by the University of Waterloo and Boston College found the accuracy of target prices averages around 18% for a three-month horizon and 30% for a 12-month one.
An advantage of a price target is it offers a degree of precision that is not possible with a crude ‘buy’ or ‘sell’ recommendation. Targets are typically based on some measure of intrinsic or relative value and the methodology used to calculate them will depend on the relevant sector and maturity of the company.
The absolute, or intrinsic value of a company is usually established using a discounted cash flow (DCF) calculation. Cash flow is the ultimate driver of value and DCF models are used to work out what the future cash flows of a company are worth in today’s money, or their net present value (NPV). It is a useful tool when looking at a company which is at the pre-revenue stage and is developing a long-term project. The four key elements that go towards making up a DCF are:
• A basic operating free cash flow calculation (OpFcF).
• Establishing forecasts for OpFcF over a long-term period, perhaps the next 10 years.
• Determining the weighted average cost of capital (WACC). WACC calculates a firm’s cost of capital where each category of capital, be it long-term bank debt, equity or bond financing is proportionately weighted.
• Discounting future OpFcF using the WACC to establish an intrinsic value for the equity.
For some companies it can be appropriate to use a NAV calculation to generate a price target. The NAV per share – also known as book value (BV) – is arrived at by dividing ‘shareholders equity’ in the balance sheet by the number of shares in issue. Shareholders equity is total assets less total liabilities and is an expression of the net worth of a company. The future value of assets is usually calculated using a DCF.
When a company is already generating profits and cash an analyst has the option of employing an earnings or cash flow-based metric to help them generate their price target. Often this will be used to determine if it is trading at a discount or premium to the average for its sector. The simplest metric is the price/earnings (PE) ratio. This is calculated by dividing the share price by the forecast after-tax earnings per share (EPS) number.
Another benchmark used by analysts is enterprise value (EV). This is derived by adding a company’s forecast debt and subtracting its forecast cash from the market capitalisation. This figure effectively tells you how much it would cost to acquire the firm.
It can then be used against a measure of earnings or cash generation to give a relative valuation. This includes the EV/EBITDA (earnings before interest, tax, depreciation or amortisation) and EV/OpFcF ratios – the latter of which can be used to come up with a free cash flow (FCF) yield.