Investment Banking For Dummies. Matthew Krantz
hide how they feel about stocks. Right at the top of most research reports is the recommendation, typically a phrase that tells investors what the analysts think about buying the investment. Most analysts use one of the following terms: “strong buy,” “buy,” “hold,” “sell,” or “strong sell.” Many beginning investors tend to place too much emphasis on the recommendation. Sure, it’s easy to just see if the analyst rates the stock a “strong buy” and then run out and buy it. But savvy investors know that most of the value of the research report is in the analysis of the company and the industry, and they don’t blindly follow the recommendation.
Price target: If you visit a research analyst’s office, you may expect to find a crystal ball. Most analysts make a bold prediction of where they think the stock could be trading in the future, usually 12 months from the time of the report. The price target is usually derived using different techniques, some of which are covered later in this book, including discount cash-flow analysis.
Key statistics: Buy-side analysts use research reports to save them time. Many investors are looking for quick, at-a-glance information to help them get a feel for a company’s future. The key statistics portion of a research report typically gives investors a summary of all the numerical data points that matter, ranging from the stock price to financial ratios such as price-to-earnings ratios. In this area of the report, you’ll also find the analyst’s forecast of the company’s future earnings, a key part of creating a price target.
Highlights/summary: Research reports can get lengthy, sometimes spanning ten pages or even more if it contains in-depth information about the industry. The highlights or summary area attempts to boil all this information down to the bare essentials.
Investment opinion: In the investment opinion area, the analyst gets some room to expound a bit on the rationale behind the recommendation. If the stock is a strong buy, the analyst makes a case for that recommendation in the investment opinion section.
Business summary: Believe it or not, some investors just know companies by the trading symbol. In this part of the report, analysts usually show investors that the investment is backed by a company that generates profits and earnings. The business is summarized in this portion of the report so investors can understand the key drivers of the company.
Ratio analysis and financials: One of the best ways for investors to really dig into a company to see if it’s a good investment is by using ratio analysis. Dozens of critical financial ratios help investors assess the value and trajectory of a company. You can find out how to calculate these ratios yourself in Chapter 8. But you can save yourself some trouble, too, because most analysts calculate many of the key ratios for you in this section.
Industry outlook: One of the influences on the profitability of a company is the industry that it’s in. Stocks in the grocery-store industry, for instance, typically keep a small portion of revenue as profit, while technology companies that make software and Internet services tend to keep a much higher percentage of their revenue. This part of the research report explains the industry and goes into what bearing that line of business has for the company.
Ways to look beyond the “buy” or “sell”
Sell-side analysts working at firms that do investment banking sometimes get looked at somewhat suspiciously. There’s a concern, sometimes warranted, that the sell-side research analysts are being overly bullish on companies because they’re clients of the firm. And in the past, such wrongdoing has been found.
But ignoring the work of sell-side analysts, simply because of a risk of conflict is a mistake. Remember: Sell-side analysts have the time to really dig into a company. Most sell-side analysts also follow several companies in the industry so they can spot broad trends that have ramifications on short-term movements of the stocks.
Focusing on everything but the recommendation: Sure, it’s easy to just look at the front page of a report and scan for the buy or sell. But doing so leaves out much of the most valuable information sell-side analysts provide. Look at how the price target is arrived at. What assumptions is the analyst making? The thinking behind the recommendation is more valuable than the recommendation itself. Sell-side analysts are often criticized for never meeting a company they didn’t like and have a “buy” rating on seemingly every company in existence. And it’s true that sell-side analysts traditionally rank many more companies as strong buys than strong sells. That’s just a natural bias of the industry that anyone working with the investment banking industry needs to keep in mind. Also, remember that sell-side analysts rarely call stocks a “sell.” With many analysts, hold is actually the euphemistic term for “sell.”
Not overlooking independent research: Although large Wall Street firms with giant investment banking operations dominate research, they’re not alone. There are firms, like CFRA and Morningstar, that generate research that aren’t connected with any investment banking. Compare the opinions of independent analysts with those of sell-side analysts to see where they differ.
Concentrating on larger industry analysis reports: Many leading sell-side analysts periodically (sometimes once a year) put out monstrous reviews of an industry. These reports are usually the best work many analysts put out. Because the reports are broad, the analysts don’t have to be as mindful about potentially upsetting companies that happen to be big clients of the firm. These reports also give the analysts more freedom to share their insights about the business. And don’t overlook the research from boutique investment banking firms, which typically focus on a narrow number of industries. These firms can share profound insights about an industry you don’t want to miss.
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