In this introductory chapter, we address some basic questions: What is value? Who uses equity valuations? What is the importance of industry knowledge? How can the analyst effectively communicate his analysis? This chapter answers these and other questions and lays a foundation for the remainder of this book.

The balance of this chapter is organized as follows: Section 2 defines value and describes the various uses of equity valuation. Section 3 examines the steps in the valuation process, including a discussion of the analyst’s role and responsibilities. Section 4 discusses how valuation results are communicated and provides some guidance on the content and format of an effective research report. Section 5 summarizes the chapter, and practice problems conclude it.

An important theoretical counter to the notion that market price and intrinsic value are identical can be found in the Grossman-Stiglitz paradox. If market prices, which are essentially freely obtainable, perfectly reflect a security’s intrinsic value, then a rational investor would not incur the costs of obtaining and analyzing information to obtain a second estimate of the security’s value. If no investor obtains and analyzes information about a security, however, then how can the market price reflect the security’s intrinsic value? The rational efficient markets formulation(Grossman and Stiglitz 1980) recognizes that investors will not rationally incur the expenses of gathering information unless they expect to be rewarded by higher gross returns compared with the free alternative of accepting the market price. Furthermore, modern theorists recognize that when intrinsic value is difficult to determine, as is the case for common stock, and when trading costs exist, even further room exists for price to diverge from value (Lee, Myers, and Swaminathan 1999).

Thus, analysts often view market prices both with respect and with skepticism. They seek to identify mispricing. At the same time, they often rely on price eventually converging to intrinsic value. They also recognize distinctions among the levels of market efficiency in different markets or tiers of markets (for example, stocks heavily followed by analysts and stocks neglected by analysts). Overall, equity valuation, when applied to market-traded securities, admits the possibility of mispricing. Throughout this book, then, we distinguish between the market price, P, and the intrinsic value (“value” for short), V.

For an active investment manager, valuation is an inherent part of the attempt to produce investment returns that exceed the returns commensurate with the investment’s risk; that is, positive excess risk-adjusted return. An excess risk-adjusted return is also called an abnormal return or alpha. (Return concepts are more fully discussed in Chapter 2.) The active investment manager hopes to capture a positive alpha as a result of his efforts to estimate intrinsic value. Any departure of market price from the manager’s estimate of intrinsic value is a perceived mispricing(a difference between the estimated intrinsic value and the market price of an asset).

These ideas can be illuminated through the following expression that identifies two possible sources of perceived mispricing:¹ where

This expression states that the difference between a valuation estimate and the prevailing market price is, by definition, equal to the sum of two components. The first component is the true mispricing, that is, the difference between the true but unobservable intrinsic value V and the observed market price P(this difference contributes to the abnormal return). The second component is the difference between the valuation estimate and the true but unobservable intrinsic value, that is, the error in the estimate of the intrinsic value.

To obtain a useful estimate of intrinsic value, an analyst must combine accurate forecasts with an appropriate valuation model. The quality of the analyst’s forecasts, in particular the expectational inputs used in valuation models, is a key element in determining investment success. For an active security selection to be consistently successful, the manager’s expectations must differ from consensus expectations and be, on average, correct as well.

Uncertainty is constantly present in equity valuation. Confidence in one’s expectations is always realistically partial. In applying any valuation approach, analysts can never be sure that they have accounted for all the sources of risk reflected in an asset’s price. Because competing equity risk models will always exist, there is no obvious final resolution to this dilemma. Even if an analyst makes adequate risk adjustments, develops accurate forecasts, and employs appropriate valuation models, success is not assured. Temporal market conditions may prevent the investor from capturing the benefits of any perceived mispricing. Convergence of the market price to perceived intrinsic value may not happen within the investor’s investment horizon, if at all. So, besides evidence of mispricing, some active investors look for the presence of a particular market or corporate event (catalyst) that will cause the marketplace to reevaluate a company’s prospects.

Nevertheless, a going-concern assumption may not be appropriate for a company in financial distress. An alternative to a company’s going-concern value is its value if it were dissolved and its assets sold individually, known as its liquidation value. For many companies, the value added by assets working together and by human capital applied to managing those assets makes estimated going-concern value greater than liquidation value (although a persistently unprofitable business may be worth more dead than alive). Beyond the value added by assets working together or by applying managerial skill to those assets, the value of a company’s assets would likely differ depending on the time frame available for liquidating them. For example, the value of nonperishable inventory that had to be immediately liquidated would typically be lower than the value of inventory that could be sold during a longer period of time, in an orderly fashion. Thus, concepts such as orderly liquidation value are sometimes distinguished.

Assuming the marketplace has confidence that the company’s management is acting in the owners’ best interests, market prices should tend, in the long run, to reflect fair market value. In some situations, however, an asset is worth more to a particular buyer (e.g., because of potential operating synergies). The concept of value to a specific buyer taking account of potential synergies and based on the investor’s requirements and expectations is called investment value.

Example 1-1 describes the market reaction to an earnings release by Intel in 2000. A retrospective on Intel eight years later (in September 2008, the company’s share price was around $20) illustrates the difficulty of equity valuation and the risk to growth stocks from disappointing results as compared to optimistic previous expectations. This example also illustrates that differences between market price and intrinsic value sometimes persist, offering opportunities for the astute investment manager to generate alpha.

Various frameworks exist for industry and competitive analysis. The primary usefulness of such frameworks is that they can help ensure that an analysis gives appropriate attention to the most important economic drivers of a business. In other words, the objective is not to prepare some formal framework representing industry structure or corporate strategy, but rather to use a framework to organize thoughts about an industry and to better understand a company’s prospects for success in competition with other companies in that industry. Further, although frameworks can provide a template, obviously the informational content added by an analyst makes the framework relevant to valuation. Ultimately, an industry and competitive analysis should highlight which aspects of a company’s business present the greatest challenges and opportunities and should thus be the subject of further investigation, and/ or more extensive sensitivity analysis(an analysis to determine how changes in an assumed input would affect the outcome of an analysis). Frameworks may be useful as analysts focus on the following questions relevant to understanding a business.

Porter’s (1985, 2008) five forces characterizing industry structure are summarized here with an explanation of how each could positively affect inherent industry profitability. For each force, the opposite situation would negatively affect inherent industry profitability.

In examining financial and operational strategic execution, two caveats merit mention. First, the importance of qualitative, that is, nonnumeric factors must be considered. Such nonnumeric factors include, for example, the company’s ownership structure, its intellectual and physical property, the terms of its intangible assets such as licenses and franchise agreements, and the potential consequences of legal disputes or other contingent liabilities. Second, it is important to avoid simply extrapolating past operating results when forecasting future performance. In general, economic and technological forces can often contribute to the phenomenon of regression toward the mean. Specifically, successful companies tend to draw more competitors into their industries and find that their ability to generate above-average profits comes under pressure. Conversely, poorly performing companies are often restructured in such a manner as to improve their long-term profitability. Thus, in many cases, analysts making long-term-horizon growth forecasts for a company’s earnings and profits (e.g., forecasts beyond the next 10 years) plausibly assume company convergence toward the forecasted average growth rate for the underlying economy.

With newer companies, or companies involved in creating new products or markets, nonfinancial measures may be critical to obtaining an accurate picture of corporate prospects. For example, a biotechnology company’s clinical trial results or an Internet company’s unique visitors per day may provide information helpful for evaluating future revenue.

Regulatory requirements concerning disclosures and filings vary internationally. In some markets, such as Canada and the United States, some mandatory filings require management to provide industry and competitive information, and access to those filings is freely available on the Internet (e.g., www.sedar.com for Canadian filings and at www.sec.gov for U.S. filings). To take the case of the United States, in annual filings with the Securities and Exchange Commission made on Form 10-K for U.S. companies and Form 20-F for non-U.S. companies, companies provide industry and competitive information in the sections for business description and for management discussion and analysis (MD&A). Interim filings (e.g., the quarterly SEC Form 10-Q for U.S. companies and Form 6-K for non-U.S. companies) provide interim financial statements but typically less detailed coverage of industry and competition.

So far as analyst-management contacts are concerned, analysts must be aware when regulations (e.g., Regulation FD in the United States) prohibit companies from disclosing material nonpublic information to analysts without also disseminating that information to the public.⁴ General management insights based on public information, however, can still be useful to analysts, and many analysts consider in-person meetings with a company’s management to be essential to understanding a company.

The CFA Institute Code of Ethics and Standards of Professional Conduct prohibit use of material inside information, and Regulation FD (and similar regulations in other countries) is designed to prohibit companies from selectively offering such information. These ethical and legal requirements assist analysts by clarifying their main role and purpose.

Company-provided sources of information in addition to regulatory filings include press releases and investor relations materials. The press releases of most relevance to analysts are the press releases that companies issue to announce their periodic earnings. Companies typically issue these earnings press releases several weeks after the end of an accounting period and several weeks before they file their interim financial statements. Earnings press releases summarize the company’s performance for the period, usually include explanations for the performance, and usually include financial statements (often abbreviated versions). Following their earnings press releases, many companies host conference calls in which they further elaborate on their reported performance and typically allocate some time to answer questions posed by analysts. On their corporate web sites, many companies post audio downloads and transcripts of conference calls and of presentations made in analyst conferences. The audio files and transcripts of conference calls and conference presentations provide access not only to the company’s reports but also to analysts’ questions and the company’s answers to those questions.

Apart from company-provided sources of information, analysts also obtain information from third-party sources such as industry organizations, regulatory agencies, and commercial providers of market intelligence.

The term quality of earnings analysis broadly includes the scrutiny of all financial statements, including the balance sheet, to evaluate both the sustainability of a company’s performance and how accurately the reported information reflects economic reality. Equity analysts will generally develop better insights into a company and improve forecast accuracy by developing an ability to assess a company’s quality of earnings. With regard to sustainability of performance, an analyst aims to identify aspects of reported performance that are less likely to recur. For example, earnings with significant components of nonrecurring events such as positive litigation settlements, nonpermanent tax reductions, or gains on sales of nonoperating assets are considered to be of lower quality than earnings derived mainly from the company’s core business operations.

In addition to identifying nonrecurring events, an analyst aims to identify reporting decisions that may result in a level of reported earnings that is unlikely to continue. A good starting point for this type of quality of earnings analysis is a comparison of a company’s net income with its operating cash flow. As a simple hypothetical example, consider a company that generates revenues and net income but no operating cash flow because it makes all sales on account and never collects its receivables. One systematic way to make the comparison is to decompose net income into a cash component (combining operating and investing cash flows) and an accrual component (defined as net income minus the cash component). Capital markets research shows that the cash component is more persistent than the accrual component of earnings, with the result that a company with a relatively higher amount of current accruals will have a relatively lower ROA in the future (Sloan 1996). Here, greater persistency means that, compared to accruals in the current period, the cash component in the current period is more predictive of future net income. A relatively higher proportion of accruals can be interpreted as lower earnings quality.

A quality of earnings analysis for a particular company requires careful scrutiny of accounting statements, footnotes, and other relevant disclosures. Sources for studying quality of earnings analysis and accounting risk factors include Richardson and Tuna (2009), Mulford and Comiskey (2005), and Schilit (2002), as well as the American Institute of Certified Public Accountants’Consideration of Fraud in a Financial Statement Audit(28 February 2002) and the International Federation of Accountants, International Standards on Auditing 240, The Auditor’s Responsibility to Consider Fraud and Error in an Audit of Financial Statements(March 2001). Examples of a few of the many available indicators of possible problems with a company’s quality of earnings are provided in Exhibit 1-1.

Example 1-3 illustrates the importance of accounting practices in influencing reported financial results and the need for analysts to exercise judgment when using those results in any valuation model.

The next example of poor earnings quality (Example 1-4), in which management made choices going beyond making an aggressive estimate, is reminiscent of a humorous vignette from Benjamin Graham in which the chairman of a company outlines plans for a return to profitability, as follows: “Contrary to expectations, no changes will be made in the company’s manufacturing or selling policies. Instead, the bookkeeping system is to be entirely revamped. By adopting and further improving a number of modern accounting and financial devices, the corporation’s earning power will be amazingly transformed” (Graham 1936).

In general, growth in an asset account (such as deferred costs in the Livent example) at a much faster rate than the growth rate of sales may indicate aggressive accounting. Analysts recognize a variety of risk factors that may signal possible future negative surprises. A working selection of these risk factors would include the following (AICPA 2002):

Companies do business within larger contexts of particular industries, national economies, and world trade. Viewing a company within those larger contexts, a top-down forecasting approach moves from international and national macroeconomic forecasts to industry forecasts and then to individual company and asset forecasts.⁶ For example, a revenue forecast for a major home appliance manufacturer could start with industry unit sales forecasts that are in turn based on GDP forecasts. Forecasted company unit sales would equal forecasted industry unit sales multiplied by the appliance manufacturer’s forecasted market share. A revenue projection would be based on forecasted company unit sales and sales prices.

Alternatively, a bottom-up forecasting approach aggregates forecasts at a micro level to larger scale forecasts, under specific assumptions. For example, a clothing retailer may have several stores in operation with two new stores about to open. Using information based on the sales per square meter of the existing stores (perhaps during their initial period of operation), the analyst could forecast sales per square meter of the new stores that, added to forecasts of a similar type for existing stores, would give a sales forecast for the company as a whole. In making such a bottom-up sales forecast, the analyst would be making assumptions about selling prices and merchandise costs. Forecasts for individual retailers could be aggregated into forecasts for the group, continuing in a bottom-up fashion.

In general, analysts integrate insights from industry and competitive analysis with financial statement analysis to formulate specific forecasts of such items as a company’s sales, earnings, and cash flow. Analysts generally consider qualitative as well as quantitative factors in financial forecasting and valuation. For example, an analyst might modify his forecasts and valuation judgments based on qualitative factors, such as the analyst’s opinion about the business acumen and integrity of management, and/or the transparency and quality of a company’s accounting practices. Such qualitative factors are necessarily subjective.

A present value model or discounted cash flow model applied to equity valuation derives the value of common stock as the present or discounted value of its expected future cash flows.⁷ For common stock, one familiar type of cash flow is dividends, which are discretionary distributions to shareholders authorized by a corporation’s board of directors. Dividends represent cash flows at the shareholder level in the sense that they are paid directly to shareholders. Present value models based on dividends are called dividend discount models. Rather than defining cash flows as dividends, analysts frequently define cash flows at the company level. Common shareholders in principle have an equity ownership claim on the balance of the cash flows generated by a company after payments have been made to claimants senior to common equity, such as bondholders and preferred stockholders (and the government as well, which takes taxes), whether such flows are distributed in the form of dividends or not.

The two main company-level definitions of cash flow in current use are free cash flow and residual income. Free cash flow is based on cash flow from operations but takes into account the reinvestment in fixed assets and working capital necessary for a going concern. The free cash flow to equity model defines cash flow net of payments to providers of debt, whereas the free cash flow to the firm model defines cash flows before those payments. We define free cash flow and each model with more precision in later chapters. Residual income models are based on accrual accounting earnings in excess of the opportunity cost of generating those earnings.

Because the present value approach is the familiar technique for valuing bonds,⁸ it is helpful to contrast the application of present value models to equity valuation with present value models as applied to bond valuation. The application of present value models to common stock typically involves greater uncertainty than is the case with bonds; that uncertainty centers on two critical inputs for present value models—the cash flows and the discount rate(s). Bond valuation discounts a stream of cash payments specified in a legal contract (the bond indenture). In contrast, in equity valuation an analyst must define the specific cash flow stream to be valued—dividends or free cash flow—and then forecast the amounts of those cash flows. Unlike bond valuation, no cash flow stream is contractually owed to common stockholders. Clearly, a company’s total cash flows, and therefore the cash flows potentially available to common stockholders, will be affected by business, financial, technological, and other factors and are subject to greater variation than the contractual cash flow of a bond. Furthermore, the forecasts for common stock cash flows extend indefinitely into the future because common stock has no maturity date. In addition to the greater uncertainty involved in forecasting cash flows for equity valuation, significant uncertainty exists in estimating an appropriate rate at which to discount those cash flows. In contrast with bond valuation, in which a discount rate can usually be based on market interest rates and bond ratings, equity valuation typically involves a more subjective and uncertain assessment of the appropriate discount rate.⁹ Finally, in addition to the uncertainty associated with cash flows and discount rates, the equity analyst may need to address other issues, such as the value of corporate control or the value of unused assets.

The present value approach applied to stock valuation, therefore, presents a high order of complexity. Present value models are ambitious in what they attempt—an estimate of intrinsic value—and offer many challenges in application. Graham and Dodd (1934) suggested that the analyst consider stating a range of intrinsic values, and that suggestion remains a valid one. To that end, sensitivity analysis is an essential tool in applying discounted cash flow valuation. We discuss sensitivity analysis in more detail below.

Another type of absolute valuation is asset-based valuation that values a company on the basis of the market value of the assets or resources it controls. For appropriate companies, asset-based valuation can provide an independent estimate of value, and an analyst typically finds alternative, independent estimates of value to be useful. Example 1-5 describes instances in which this approach to absolute valuation could be appropriate.

Perhaps the most familiar price multiple is the price-to-earnings ratio (P/E), which is the ratio of a stock’s market price to the company’s earnings per share. A stock selling at a P/E that is low relative to the P/E of another closely comparable stock (in terms of anticipated earnings growth rates and risk, for example) is relatively undervalued (a good buy) relative to the comparison stock. For brevity, an analyst might state simply undervalued, but the analyst must realize that if the comparison stock is overvalued (in an absolute sense, in relation to intrinsic value), so might be the stock being called undervalued. Therefore, it is useful to maintain the distinction between undervalued and relatively undervalued. Investing to exploit perceived mispricing in either case (absolute or relative mispricing) relies on a basis of differential expectations, that is, investor expectations that differ from and are more accurate than those reflected in market prices, as discussed earlier.

The more conservative investing strategies based on relative valuation involve over-weighting (underweighting) relatively undervalued (overvalued) assets, with reference to benchmark weights. The more aggressive strategies allow short-selling of perceived overvalued assets. Such aggressive approaches are known as relative value investing(or relative spread investing, if using implied discount factors). A classic example is pairs trading that utilizes pairs of closely related stocks (e.g., two automotive stocks), buying the relatively undervalued stock and selling short the relatively overvalued stock. Regardless of which direction the overall stock market goes, the investor will be better off to the extent that the relatively undervalued stock ultimately rises more (falls less) than the relatively overvalued stock.

Frequently, relative valuation involves a group of comparison assets, such as an industry group, rather than a single comparison asset. The application of relative valuation to equity is often called the method of comparables(or just comparables) and is the subject of Chapter 6.

The method of comparables is characterized by a wide range of possible implementation choices; Chapter 6 discusses various alternative price and enterprise multiples. Practitioners will often examine a number of price and enterprise multiples for the complementary information they can provide. In summary, the method of comparables does not specify intrinsic value without making the further assumption that the comparison asset is fairly valued. The method of comparables has the advantages of being simple, related to market prices, and grounded in a sound economic principle (that similar assets should sell at similar prices). Price and enterprise multiples are widely recognized by investors, so analysts can communicate the results of an absolute valuation in terms of a price or enterprise multiple.

Each of these valuation methods could potentially be applied either to the total entity or to one or more of its component parts. Example 1-7, showing a case in which a sum-of-the-parts valuation approach would be appropriate, refers to in-process research and development. In-process research and development(IPRD) are R&D costs relating to projects that are not yet completed, such as have been incurred by a company that is being acquired.

The concept of a conglomerate discount often arises in connection with situations warranting a sum-of-the parts valuation. Conglomerate discount refers to the concept that the market applies a discount to the stock of a company operating in multiple, unrelated businesses compared to the stock of companies with narrower focuses. Alternative explanations for the conglomerate discount include (1) inefficiency of internal capital markets (i.e., companies’ allocation of investment capital among divisions does not maximize overall shareholder value), (2) endogenous factors (i.e., poorly performing companies tend to expand by making acquisitions in unrelated businesses), and (3) research measurement errors (i.e., conglomerate discounts do not actually exist, and evidence suggesting that they do is a result of flawed measurement). ¹⁰ Examples in which conglomerate discounts appear most observable occur when companies divest parts of the company that have limited synergies with their core businesses.

Note that a breakup value in excess of a company’s unadjusted going-concern value may prompt strategic actions such as a divestiture or spin-off.

Selection of a model consistent with the characteristics of the company being valued is facilitated by having a good understanding of the business, which is the first step in the valuation process. Part of understanding a company is understanding the nature of its assets and how it uses those assets to create value. For example, a bank is composed largely of marketable or potentially marketable assets and securities; thus, for a bank, a relative valuation based on assets (as recognized in accounting) has more relevance than a similar exercise for a service company with few marketable assets.

In selecting a model, data availability and quality can be limiting factors. For example, a dividend discount model is the simplest discounted cash flow model; but if a company has never paid dividends and no other information exists to assess a company’s future dividend policy, an analyst may have more confidence applying an apparently more complex present value model. Similar considerations also apply in selecting a specific relative valuation approach. For example, meaningful comparisons using P/Es may be hard to make for a company with highly volatile or persistently negative earnings.

Model selection can also be influenced by the purpose of the valuation or the perspective of the analyst. For example, an investor seeking a controlling equity position in a company may elect to value the company based on forecasted free cash flows rather than forecasted dividends because such flows might potentially be redirected by such an acquirer without affecting the value of the acquisition (this valuation approach is discussed in detail in Chapter 4). When an analyst reads valuations and research reports prepared by others, the analyst should consider how the writer’s perspective (and potential biases) may have affected the choice of a particular valuation approach and/or valuation inputs. Later chapters, discussing present value models and price multiples, offer specific guidance on model selection.

As a final note to this introduction of model selection, it is important to recognize that professionals frequently use multiple valuation models or factors in common stock selection. According to the Merrill Lynch Institutional Factor Survey(2006), respondent institutional investors report using an average of approximately nine valuation factors in selecting stocks.¹¹ There are a variety of ways in which multiple factors can be used in stock selection. One prominent way, stock screens, is discussed in Chapter 6. As another example, analysts can rank each security in a given investment universe by relative attractiveness according to a particular valuation factor. The rankings for individual securities could be combined into a single composite ranking by assigning weights to the individual factors. Analysts may use a quantitative model to assign those weights.

Sensitivity analysis is an analysis to determine how changes in an assumed input would affect the outcome. Some sensitivity analyses are common to most valuations. For example, a sensitivity analysis can be used to assess how a change in assumptions about a company’s future growth—for example, decomposed by sales growth forecasts and margin forecasts—and/or a change in discount rates would affect the estimated value. Other sensitivity analyses depend on the context. For example, assume an analyst is aware that a competitor to the target company plans to introduce a competing product. Given uncertainty about the target company’s competitive response—will the company lower prices to retain market share, offer discounts to its distributors, increase advertising, or change a product feature—the analyst could create a baseline forecast and then analyze how different competitive responses would affect the forecasted financials and in turn the estimated valuation.

Situational adjustments may be required to incorporate the valuation impact of specific issues. Three such issues that could affect value estimates are control premiums, lack of marketability discounts, and illiquidity discounts. A controlling ownership position in a company (e.g., more than 50 percent of outstanding shares, although a far smaller percentage often affords an investor the ability to significantly influence a company) carries with it control of the board of directors and the valuable options of redeploying the company’s assets or changing the company’s capital structure. The value of a stock investment that would give an investor a controlling position will generally reflect a control premium; that is, it will be higher than a valuation produced by a generic quantitative valuation expression that did not explicitly model such a premium. A second issue generally not explicitly modeled is that investors require an extra return to compensate for lack of a public market or lack of marketability. The value of non-publicly traded stocks generally reflects a lack of marketability discount. Among publicly traded (i.e., marketable) stocks, the prices of shares with less depth to their markets (less liquidity) often reflect an illiquidity discount. An illiquidity discount would also apply if an investor wishes to sell an amount of stock that is large relative to that stock’s trading volume (assuming it is not large enough to constitute a controlling ownership). The price that could be realized for that block of shares would generally be lower than the market price for a smaller amount of stock, a so-called blockage factor.¹²

In conducting their valuation activities, investment analysts play a critical role in collecting, organizing, analyzing, and communicating corporate information, and in some contexts, recommending appropriate investment actions based on sound analysis. When they do those tasks well, analysts help their clients, the capital markets, and the suppliers of capital:

From the beginnings of the movement to organize financial analysis as a profession rather than as a commercial trade, one guiding principle has been that the analyst must hold himself accountable to both standards of competence and standards of conduct. Competence in investment analysis requires a high degree of training, experience, and discipline.¹⁷ Additionally, the investment professional is in a position of trust, requiring ethical conduct toward the public, clients, prospects, employers, employees, and fellow analysts. For CFA Institute members, this position of trust is reflected in the Code of Ethics and Standards of Professional Conduct, as well as in the Professional Conduct Statement that they submit annually. The Code and Standards, which guide the analyst to independent, well-researched, and well-documented analysis, are described in the following sections.

Given the importance of the estimated intrinsic value of the security, most research reports provide the reader with information about the key assumptions and expectations underlying that estimated value. The information typically includes an update on the company’s financial and operating results, a description of relevant aspects of the current macroeconomic and industry context, and an analysis and forecast for the industry and company. Because some readers of research reports are interested in background information, some reports contain detailed historical descriptive statistics about the industry and company.

A report can include specific forecasts, key valuation inputs (e.g., the estimated cost of capital), a description of the valuation model, and a discussion of qualitative factors and other considerations that affect valuation. Superior research reports also objectively address the uncertainty associated with investing in the security, and/or the valuation inputs involving the greatest amount of uncertainty. By converting forecasts into estimated intrinsic value, a comparison between intrinsic value and market price provides the basis for an investment recommendation. When a research report states a target price for a stock (based on its intrinsic value) in its investment recommendation, the report should clarify the basis for computing the target, a time frame for reaching the target, and information on the uncertainty of reaching the target. An investment recommendation may be accompanied by an explanation of the underlying rationale (i.e., investment thesis), which summarizes why a particular investment offer would provide a way to profit from the analyst’s outlook.

Although these general characteristics are all desirable attributes of a useful and respected report, in some situations the requirements are more specific. For example, regulations governing disclosures of conflicts and potential conflicts of interest vary across countries, so an analyst must remain up-to-date on relevant disclosure requirements. As another example, in some situations, investment recommendations are affected by policies of the firm employing an analyst; for example, a policy might require that a security’s price be X percent below its estimated intrinsic value to be considered a buy. Even in the absence of such a policy, an analyst needs to maintain a conceptual distinction between a “good company” and a “good investment” because returns on a common stock investment always depend on the price paid for the stock, whether the business prospects of the issuing company are good, bad, or indifferent.

Going beyond this general statement of responsibility, some specific Standards of Professional Conduct particularly relevant to an analyst writing a research report are shown in Exhibit 1-3.