Everyone knows what investment banking is, probably because the news and media often sensationalise it as a high-profile, high-paying, and fast-paced job. On the other hand, hardly anyone knows what equity research is.
Due to the similarities of both professions, equity research is regarded as the less attractive, less lucrative, and much slower-paced cousin of investment banking. Still, it’s an incredibly important aspect of finance.
When it comes to obtaining and arranging information that can be used to decide on investments, equity research is king. In fact, these days, most investment banks have an equity research department within their company for this very reason. But what is it, and how does it all work?
That’s what we’ll discuss in this article. We’ll explain what equity research is, how it makes money, what different roles there are in equity research, and more.
What is equity research?
Equity research provides investment banks, institutional investors, and clients with information on whether they should buy, sell, or hold investments. Equity researchers analyse a company from head to toe and undertake financial performance analyses to determine how a company is performing.
They assess the industry the company is in, use financial models to project and forecast a company’s performance, and value a company based on this information. They also assess what its share price might be in the future before finally recommending whether the company’s stock should be bought, sold, or held.
How does an equity research firm make money?
In most cases, an investment bank or financial institution usually has an equity research division within their company. It’s kept in-house and is used as a tool to make commission-based earnings. To explain this in an example, suppose a client such as a pension fund or mutual fund hires the services of the investment bank to conduct equity research.
Let’s say the equity research report had a recommendation to sell a particular stock. They will then redirect the client to the sales and trading department, where they will authorise the trade on behalf of the client. They will charge a commission on the transaction and, thus, make money.
Essentially, the reports generated by the equity research department will be given out for free. The client uses this information to make a trade, which they then follow through with, using the sales and trading department of the same company.
On the other hand, an independent equity research firm only provides research. It does not have a sales and trading department, so how do they make money? Well, they generate revenue by charging a rate for each report made or agreeing on a set fee for reports over a certain time period. An example of this would be if a private equity firm or financial services company hired an equity research firm for their services.
Why is equity research important?
Information is king when it comes to the financial market, stocks, and investing. Traders, investors, and financiers need information to know whether they should buy, sell, or hold. An investor with better information than other investors will be able to make the most profitable decisions, and the information has to come from somewhere. As such, the services of equity researchers can be enlisted to find this information and present it in a digestible way with actionable recommendations.
What is the difference between equity research and investment banking?
On the surface, they can seem the same since they both have overlapping goals. However, there are some key distinctions. Equity researchers’ sole purpose is to evaluate companies and provide investment recommendations. They do this by looking at the company’s performance, the industry it’s in, its share price, etc., to analyse how the company might perform in the future and how its share price will be affected.
Investment banks analyse companies in a similar way. But, they also advise businesses, governments, and clients on how to overcome financial challenges. This can be with financing, trading and sales, asset management, mergers and acquisitions, and more. As such, many investment banks have their own equity research division since research is a crucial part of achieving these goals.
What does an equity research analyst do?
As a whole, equity researchers have three main tasks – researching, reporting, and forecasting.
An equity research analyst is someone who follows recent news and trends about a company, its competitors, and its industry as a whole, taking note of relevant issues and concerns. They gather information from various sources such as industry contacts, other agencies, online information resources, and upper management of the company itself.
This information is then used to analyse the company and its stocks and assess their evaluations. They also consider a business’s cash flow and income statement, using them to deduce the value of a company. In some cases, equity research analysts can be more focused on the researching and reporting side of equity research firms, having specialist analysts who handle projections. However, most of the time, the same analyst will do both.
This information is presented in equity research reports. This can be a flash report, which conveys the overall performance of a company shortly and concisely, or an in-depth report that goes into the nitty-gritty details. These reports are then sent to investment institutions, clients, etc., and form the basis upon which they decide to buy, sell, or hold investments.
What is a sell-side equity research analyst?
A sell-side equity research analyst mainly produces reports and recommendations that their client then uses to sell investments. They do this by building models that assess a company’s financial situation, engaging in analysis, meeting and communicating with suppliers, competitors, customers, and other stakeholders.
Sell-side equity research professionals will usually have several companies they are responsible for, all within the same industry or sector. An example is companies in the consumer retail sector, oil and gas industry, etc.
What is a buy-side equity research analyst?
Buy-side equity research analysts follow a similar line of work, but they spend their time and energy on identifying the greatest performers in the market. Whereas sell-side analysts have a more niche focus and only look at a handful of companies in the same sector, buy-side analysts tend to look at a variety of industries. This means they can have their eyes on as many as 30+ companies simultaneously. This general coverage results in reports that aren’t as detailed as those made by sell-side analysts but are still helpful in assessing a company or industry, with both reports being used together.
What does an equity research associate do?
An equity research associate is charged with supporting their senior analyst as best as possible. This can come in various forms such as financial modelling, conducting and interpreting company data, preparing model valuations, industry analysis, assisting with research on a company, developing reports, remaining up to date on news and trends etc. The exact tasks equity research associates have on a day-to-day basis can often change as it depends on the exact needs of the analyst.
What is in an equity research report?
An equity research report has six main sections – industry research, an overview of the management, historical financial performance, projections and forecasting, valuation, and recommendations. Let’s look at these in more detail.
This section looks at the trends and competition of an industry and provides a whole host of information on them. Frameworks such as SWOT analysis, PEST analysis, Porter’s Five Forces, etc., will be outlined in this section as they take a holistic view of the industry. As such, factors such as politics, social trends, economic situations, new innovations, and many more will be touched on.
Overview of management
It’s often said that a company is only as good as its people. That’s why many investors want to know the people behind the business first. This section does just that, as it analyses the management structure and personnel in the company to determine their quality.
Individual investors tend not to have access to the people being a company. However, institutional investors, hedge funds, and investment banking firms can hire an equity research firm to bridge that gap. This is because equity research firms have analysts who excel at this.
Part of an equity research analyst’s job is to have access to a company’s upper management, have conducted research on them, and potentially have visited the company offices and met with them in person. They can also ask direct questions about the business to them. This information is then used to assess the competence of a company’s management personnel, which is then included in the report in this section.
Historical Financial Performance
A company’s historical performance is no guarantee of its future performance. Still, it provides helpful information that can indicate how well it may do going forward. The performance of stocks is typically based on the reality of how they performed against how well it was expected to perform.
Equity research analysts use historical data to compare how well it performed to expectations or guidance given to them and to understand if these were below or above market expectations. The findings of this analysis can be beneficial for investors.
Projections and forecasting
Projections and forecasting are complicated to do. There aren’t concrete and rigid criteria that can be used to judge how well a company will do. That’s why forecasting tends to be viewed as an art and not a science.
But, there are two general ways that analysts make projections and forecasting, both of which aim to determine how much revenue a company will make. There is the top-down method and the bottom-up method.
The top-down approach considers high-level market data, then slowly works its way ‘down’ to the company’s revenue – essentially looking at the big picture first and seeing where the company fits into it. The first step typically involves looking at the industry, such as how big it is, how fast it is – or is not – growing, pricing, etc. Then it looks at how much market share the company is expected to have in the industry compared to its competitors, thus deducing how much revenue the company can expect to make.
On the other hand, the bottom-up method considers low-level company data first. It then slowly works its way ‘up’ to the company’s revenue. Typically, this involves assessing a company’s products and how much they sold, the number of customers and other stakeholders, and then determining the expected revenue using this data.
Valuation methods build on the findings of the projections and forecasting section. If projections and forecasting are all about making assumptions, then valuations can be considered as using assumptions to make more assumptions.
There is a wide variety of valuation techniques. They require the use of financial modelling, which is why it’s a core part of an equity research analyst’s job. The models will be used to create a company valuation based on all the information from the previous four sections.
This is usually the final section of an equity research report. In this section, analysts will explain why they think the stock will or will not perform well, the price they believe it will reach in a year, and actual recommendations on whether the investor should buy, sell or hold the stock.