Equity Report - TESLA

Equity Research Report

Overview

For the equity research report, you will put yourself in the shoes of a stock analyst to study,

examine, and value your chosen company before making a buy or sell recommendation based on

the current stock price.

An equity research report is generally prepared by equity analysts in investment banking houses

to provide information to investing clients, advisors, and other interested parties about the stock’s

future potential and to recommend a purchase or sale of the stock.

The analyst would recommend buying a stock if he estimates the value of a share to be greater

than the price which you can buy it on the market. Similarly, he would make a sell recommendation

if he values the company below its current market price. There is some evidence that analyst

reports are positively biased, because of lack of incentives to produce negative reports. Of course,

you can prepare your own unbiased report and use it for your own internal consumption at the time

of investing. The idea is to find good bargains and avoid buying overvalued stocks. This is tough

because securities usually trade at their fair price if markets are fairly informationally efficient.

There are several different valuation techniques. The valuation principle you will use for to

estimate the firm’s value is known as the discounted cash flow method, or “fundamental

valuation.” You will do this by first forecasting the expected future cash flows and then discounting

those cash flows back to present value. The discount rate is based on the riskiness of the forecasted

free cash flows. After these cash flows are discounted back to present value, you adjust the

estimated firm value for debt and preferred stock outstanding, and divide by the shares outstanding

for your target stock price.

The report will contain the following sections:

Executive Summary Analyst Name and Company, Firm being analyzed: Name and

Ticker Symbol, Price on report date, Forecast horizon,

Recommendation (Buy, hold or sell; or strong buy etc.), Target

forecasted price, Highlights, Summary of analysis

Qualitative Analysis Company profile or business description, Industry overview, SWOT

analysis, Management, Major owners, News, Summary of technical

analysis and charts

Financial Statements

Analysis

Ratio Analysis and Interpretation, Earnings Forecast, Growth

forecast, Trends over time and versus competitors

Risk and Pricing Risk factors, Computation of Required return or discount rate,

Calculate Fair Price, Compare with market, Recommendation

Appendix: Actual financial statements

The report usually contains an executive summary page with the key recommendation. This

recommendation should be based on very solid justification. Next, the report details the qualitative

analysis of the firm’s business and the industry conditions. Following this, is a financial statement

analysis section which numerically forecasts earnings and future dividends. Finally, you assess the

risk factors to compute the appropriate rate at which to discount future cash flows to arrive at the

fair price that should be paid for the stock. Any factual information and the actual financial

statements should be included in the appendix. The report itself should contain the interpretation

of these facts.

Where to start

There are many potential sources of data and information about the company which you will need

to gather and review when you are preparing the report. Every listed firm is legally required to file

its statements at the publicly-accessible SEC (Securities and Exchange Commission) EDGAR

website. They will also have information on the company’s own investor relations webpage.

Bloomberg, Reuters, and the Wall Street Journal are good, albeit expensive, media and data

sources for latest news about the company. A nice free website which is an excellent source of

qualitative and quantitative financial information is Yahoo Finance. Gather all of your hard data

and source material (financials, economic outlooks, competitors’ financials, etc.) and be sure to

include them – formatted neatly – into your report’s appendix.

Qualitative Analysis

It is important to analyze each piece of information in your report. Don’t just copy it into the report;

you must interpret it. What is the meaning of each piece of information and how it will effect

stock’s fair value, in your opinion?

Your analysis will begin by using qualitative factors and analysis to determine the business

outlook. In other words, how will fundamental information affect future cash flows in the

numerator of the valuation equation?

Think about how every piece of information will affect future sales or revenues (i.e. the top line

of the income statement). Will the sales increase due to economic recovery and growth OR will

the sales decline due to competition and other factors?

Also think about how this information will affect the bottom line (i.e. EPS, free cash flows, or

dividends). Will the costs rise due to inflation, or will the firm successfully control costs and

increase profitability?

Keep in mind that sales often have patterns such as seasonality, trends, business cycles, growth

through innovation. So when you are projecting the future sales all these trends and patterns should

be helpful in making a more accurate forecast.

First, try to forecast how the overall economy will perform in the forecasting period. If the

economy grows most firms are likely to share the fruits of that growth. If the economy will be in

recession than most firms will experience declining sales. There are some exceptions such as

Walmart or inferior good manufacturers, which may do well in recession. Take this into account

when you are analyzing the GDP growth rate, which is usually forecasted by economists and

should help you to predict the firm’s growth.

Now determine the stage of the industry’s life cycle. Industries in the pioneering stage may have

losses in their initial years – Amazon had huge losses in the initial years after the website was

launched – but then these firms can earn high profit margins as the product is established.

To determine how qualitative factors will affect your firm’s top and bottom lines, you’ll need to

use your own opinions, research and creativity. This may include relevant news articles, technical

analysis/charting, a SWOT (Strengths, Weaknesses, Opportunities, Threats) matrix, and knowing

the major shareholders and managers of the firm. The possibilities are endless, but for your report,

you’ll ultimately need to forecast revenues and expenses, so you’ll need to justify them with your

analysis.

To analyze management and ownership of the firm you need to ask yourself:

Who is running the firm that you are analyzing? What is their background, skill set, and

experience? How are they paid? Cash compensation may leave managers unmotivated, options

may lead managers to take on too much risk, bonus compensation may lead to earnings

manipulation. Therefore, the best practice firms tend to use cash plus restricted stock unit

compensation for their managers. Most importantly, try to examine management’s track record of

allocating capital. i.e. how does management makes use of profits once they have been earned?

This is important because poor allocation of your profits can destroy great business, regardless of

how much profit you make. If you making dumb investments with that profit, it won’t help you

much in the long‐run.

Quantitative Analysis

Financial Statement Analysis is done to assess the financial health of a firm. Within this section,

you will compute and interpret various types of ratios, and highlight any changes in these ratios

over time and any major differences in ratios across the firm and its competitors.

The next goal is to project the firm’s EPS in the next year. The best places to start are current and

historic financial statements, (We already have this data!) and use your qualitative and ratio

analysis to determine why revenue, expenses, earnings and cash flows are moving up and down

each year.

For projecting future expenses, it is useful to common size the historic and current statements as

% of sales and then use the ratios for forecasting next year’s expenses, being sure to factor in our

qualitative analysis. Now to get the earnings per share we divide the net income by the number of

shares outstanding. A short cut to find the number of shares outstanding is to divide the Market

capitalization by price. But be mindful that firms can add more shares in future through equity

offerings, and (more commonly) the exercise of stock options by its executives. If so, then you

should increase the number of shares outstanding for the future.

Historic Data Common Size Average & Adjust Forecast

2009 2008 2009 2008 2010

Sales or

Revenues

$14.6

Billion

13.5 8%

growth

9.9%

Growth

8.95% adjust down to

6.5%; recession

$15.5

Billion

Various

Expenses (% of

sale)

$12.5

Billion

11.3 86% of

sales

84% of

sales

85% adjust down to

83%; cost cutting

measures

$12.9

Billion

Net Income $2.1

Billion

$2.2

Billion

$2.6 Billion

EPS 1.94 1.97 2.32

Risk Analysis and Pricing

Next you’ll analyze the risk of the firm to estimate an appropriate discount rate. The discount rate

should increase as the firm’s cash flows gets riskier. Some people just use a “common sense” rate

of required return. Others rely on sophisticated mathematical modeling to determine the risk

premium (the additional return in order to compensate investors for uncertainty about the stock’s

future performance) on the stock. To do this, you will require the risk free rate plus a risk premium.

The proponents of the advanced mathematical models claim that only systematic risk (and not

idiosyncratic risk) is rewarded in the stock market. This type of risk is caused by macro factors

such as changes in interest rates, GDP growth, supply shocks, financial crisis. Therefore, to

measure systematic risk, we estimate the covariance of the stock returns with the market portfolio.

This covariance is called beta (β). Beta estimates a stock’s systematic risk. Unsystematic risk is

not rewarded because you can easily reduce or eliminate it by holding well diversified portfolios.

The Capital Asset Pricing Model provides a framework for computing the required return from the

stock. Essentially, discount rate that you will put into the dominator of the valuation equation

would be the required return according to the CAPM. This required return is:

𝐸(𝑅𝑖 ) = 𝑅𝑓 + 𝛽𝑖 [𝐸(𝑅𝑚) − 𝑅𝑚]

Rf is the risk free rate, which can be estimated using the treasury bill rate. You can find this

information on US Treasury website. (http://www.ustreas.gov/offices/domestic‐finance/debt‐

management/interest‐ rate/yield.shtml) For example, the rate was 0.43% in September 2009.

You can obtain βi from Yahoo Finance or Bloomberg, or estimate it yourself by regressing 24-60

months of historic stock returns (Ri) on historic market returns (Rm).

A commonly used proxy for a forecast of market wide stock returns, Rm, is the historic S&P 500

index return. Historic average for large stocks according to many textbooks is between 10 and 12%

per year. You can then adjust this historical average to incorporate your opinion about the long

run future of the stock market.

Dividend Discount Model: Single Stage

Now that you’ve estimated future cash flows, growths rates, and the discount rate, you can now

estimate the value of the stock. This is the primary contribution of your equity report: the target

price of the stock. There are multiple methods and models used to arrive at an estimated target

price. We will cover several in this tutorial. You will need to use at least one appropriate discounted

cash flow method, but you may wish to try several different models to see how sensitive your

target price is to the assumptions implicit in each model. First, we’ll cover the single stage dividend

discount model, otherwise known as the Gordon Growth Model:

𝑃0 = 𝐷1

𝐸(𝑅𝑖 ) − 𝑔 =

𝐷0(1 + 𝑔)

𝐸(𝑅𝑖 ) − 𝑔

Suppose you’re valuing an established firm in a mature industry with a steady growth rate. If we

assume that dividends will grow at a constant rate in perpetuity, and that the require return for

equity holders doesn’t change year-to-year, we can mathematically show that the fundamental

present value of the stock is equal to next year’s dividend (D1) divided by the required return

(E(Ri)) minus the growth rate (g). Since we don’t know for sure what D1 will be a year in advance,

we can use the most recent dividend (D0), and grow it by the growth rate (1+g).

Free Cash Flow Model: Single Stage

What if the firm you’re valuing doesn’t pay a regular dividend? What if the firm’s dividends are

too erratic to be valued by a smooth growth rate? What if you are valuing a closely-held firm and

dividends aren’t public knowledge? In any of these cases, the Gordon Growth Model won’t be the

best choice, and you may need to use a discounted free cash flow model instead.

𝑉𝐹 = 𝐹𝐶𝐹𝐹1

𝑊𝐴𝐶𝐶 − 𝑔 𝑜𝑟 𝑉𝐸 =

𝐹𝐶𝐹𝐸1 𝐸(𝑅𝑖 ) − 𝑔

The models look very similar, but instead of dividends per share, you use the firm’s free cash flows

to find the overall value of the firm. BEWARE! We can use either Free Cash Flows to the Firm

(FCFF) or Free Cash Flows to Equity (FCFE), but we need to adjust our discount rate and outcome

variable accordingly. Notice that when we use FCFE, we discount by the required return of equity

holders (E(Ri)) and we calculate the value of equity (VE). This isn’t the price of each share, but the

overall value of equity, so you still need to divide this by the number of shares outstanding to

arrive at the target price per share. Now see that when we use FCFF, since we haven’t taken out

any interest payments or changes in debt, we need to discount by the weighted-average cost of

capital (WACC), and we end up calculating the value of the firm, not the value of equity. Once we

value the firm, we need to adjust this figure by subtracting off the value of debt, adding the value

of non-operational assets (investment property, stock in other companies, etc.), and then dividing

by the shares outstanding to arrive at the target price per share.

Multi-stage Discounted Cash Flow Models

What if you’re valuing a firm with a growth rate higher than the required return on equity? This

will give you a negative valuation in the single stage growth models (technically, we derived the

Gordon Growth Model using a Taylor-series expansion which assumes E(Ri) > g, so if this isn’t

the case, we get an infinite value, not negative). What if you’re valuing a firm in the early stages

of its industry, and the growth rate will be very high for a few years before coming back down to

a terminal growth rate (gt)? In either case, you’ll have to use a multi-stage growth model. The good

news is that the multi-stage models work with either dividends or free cash flows. You just need

to use the appropriate discount rate (k) depending on which cash flow (CF) you’re using – D,

FCFF, or FCFE.

𝑉0 = 𝐶𝐹1

(1 + 𝑘) +

𝐶𝐹2 (1 + 𝑘)2

+ ⋯ 𝐶𝐹𝑡 + 𝑉𝑡 (1 + 𝑘)𝑡

, 𝑤ℎ𝑒𝑟𝑒 𝑉𝑡 = 𝐶𝐹𝑡+1 𝑘 − 𝑔𝑡

This model, especially when used with FCFF, gives you the most control and the flexibility to

value any firm, but it is also the most labor intensive and complex because you have to forecast

cash flows for t or (t+1) years. Remember, if you’re using free cash flows, you’ll still have to make

the appropriate adjustments to go from the value estimate to the target price per share.

Valuation based on Price Multiples

An alternative approach to this is to project a price multiple for the firm. We have already projected

earnings per share (EPS) in the financial statement analysis and now we are trying to find the fair

price, P0. So we can use EPS times the projected price to earnings multiple (P/E). In order to get

this forecasted price to earnings multiple, you can use various benchmarks such as historic,

industry-average, market-wide average. You don’t have to stop at the P/E ratio. Since earnings can

sometimes be negative, it’s not uncommon to use a Price/Sales multiple. Since earnings is

influenced by some arbitrary accounting principles, many finance people prefer price-to-cash flow

multiples. In the early 2000s, many “dot com” firms didn’t even have revenue, but they needed

money from investors. How were they valued? Venture capitalists used price-to-click multiples

for several of these firms. While your imagination may be the limit, the P/E multiple is probably

the safest. Since the terminal firm value (Vt) is hard to estimate so far into the future, some analysts

use multiples to estimate the terminal firm value. Multiple valuation can give you slightly different

estimates for the fair price of the stock. Depending on what method you use and your assumptions,

you might get different estimates of the fair price. At the end you can use plain average or weighted

average from the different approaches to forecast the stock price in the future.

Once you can have the fair price, you will then make your recommendation on the stock.

– Recommend a purchase if market price is significantly less than your target price

– Recommend selling if the market price is significantly higher than your target price

– You can recommend holding the stock if the market price is too close to your target price to

generate a decent return

It is good practice to calculate the potential return based on today’s price and your target price.

Finally, it is a very good idea to perform sensitivity analysis or scenario analysis. In short, vary

your assumptions about sales and/or costs to learn what might happen to the stock price under

optimistic or pessimistic scenarios for the stock. The stock’s price is going to be most sensitive to

your assumptions about required return and terminal growth rate, so it’s good to vary these and

see what ranges give you buy, sell, or hold recommendations.

Project Grading Breakdown:

Section Points

Executive Summary 10

Qualitative Analysis 30

Financial Statement Analysis 20

Risk and pricing 30

Overall Quality 10

Total 100