Equity Research and Financial Models
Equity research analysts seek to provide a clear understanding and valuation of publicly-traded companies, and one of their primary tools is financial modeling. A financial model is essentially a representation or simulation of a company's financial performance. It is built in a structured way that allows for inputs (like historical financial data or assumptions) to generate outputs (like future financial projections). By using these models, equity researchers can estimate a company's intrinsic value and determine whether the stock is overvalued or undervalued.
Types of Financial Models:
Discounted Cash Flow (DCF) Model: This is one of the most common valuation methods used in equity research. The DCF model projects a company's future cash flows and then discounts them back to the present value using a discount rate (usually the company's weighted average cost of capital or WACC). If the present value of these cash flows (plus any terminal value) is higher than the company's current market capitalization, then the stock could be considered undervalued, and vice versa.
Comparable Company Analysis (Comps): Analysts compare the valuation multiples (like P/E, EV/EBITDA) of the company they're researching to those of similar, publicly-traded companies. This provides a relative valuation and helps analysts determine if the company is trading at a premium or discount to its peers.
Precedent Transaction Analysis: This method looks at recent M&A transactions in the sector to determine how much acquirers have paid for companies. This helps in gauging the potential value of a company if it were to be acquired.
Financial Statement Models: These models are detailed representations of a company's three main financial statements: income statement, balance sheet, and cash flow statement. They are interconnected and allow for projections. Analysts can make assumptions about the future, such as revenue growth or margin changes, and see how they impact the company’s overall financial health.
Leveraged Buyout (LBO) Model: Less commonly used in standard equity research, the LBO model evaluates the returns an investor could expect if they purchased a company using a significant amount of debt.
Sum-of-the-Parts (SOTP) Model: Used for conglomerates or diversified companies with distinct business units, this model values each segment or business unit separately. The aggregate of these individual valuations gives the total value of the company.
In summary, financial models enable equity research analysts to make informed projections about a company's future performance and derive a valuation for the firm. The types of models they choose depend on the specific context and nature of the company and industry they are analyzing.
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