Equity Analysis Framework
Equity Analysis Framework XIII (Oct-20)
- Metrics: FCF yield, EPV, ROIC vs. WACC, gross margin
A: Firm level
1. Cash generation: How does this business make money?
a. What is the product?
i. Demand side / supply side competitive advantage / niche + economies of scale
ii. Is the strategy, differentiated product or cost leadership?
1. NPS score / gross margin indicate demand side advantage
iii. Consider total cost of ownership vs. competitors
iv. Is there a back-end monopoly to be created
b. What is the build to revenue; GDP -> End Market -> Consumer spend / Opex / Capex à Market Share = Revenue
c. Who are the customers / which end markets does it sell into? (Verticals or Geographies)
i. Is growth (1) Structural, (2) Cyclical or (3) Secular Trend
ii. How competitive is each deal/win is? (e.g. is the product chosen off the shelf / via distribution / competitive tender)
2. Growth Driver?
a. What are growth drivers:
i. Volume (Growing TAM / Market Share) Q
1. New products/geographies (difficult to replicate e.g. groceries vs. Nike)
2. If Rev grows faster than end market, how is the increasing market share jusitifed?
ii. Pricing (P)
iii. Product Mix
b. Is there a conscious tradeoff between growth and EBITDA?
c. Find Margin & Growth (FCF Margin)
d. Forecasts should be backed by business assumptions (typically linked to value chain or competition)
3. Cost Structure
a. Operating leverage — What are the fixed costs / variable costs
b. How much investment in assets is required to generate return (return on book / tangibles)?
c. What direction is R&D / S&M trending?
i. How advantageous is scale?
d. “exceptionals”
B: Industry / Competitive Advantage
4. What markets is this company competing in (product / price segment / geography)
5. Competitive Advantage
a. Check — differentiation or cost leadership?
b. Do competitive advantages exist?
i. Stability of market share / frequency of new entrants
ii. If no à OPERATIONAL EFFICIENCY
c. Moat / Franchise: (1) Government enabled (2) Switching Costs (3) Search Costs (4) Network Effects (value increases w/ user base) (5) Cost & Demand advantage
d. Does high operating leverage create scale-related competitive advantages?
e. If RoA is high, threat from incumbents? / One disruptor
6. If the market is growing, does the firm benefit from being early or are there vintage effects (high cost of learning, initial investment)
7. Where do you sit in the value chain; how strong are suppliers and if favourable market structure, are profits going to flow there?
C: Balance Sheet Quality
1. Look at debt capacity (a) Leverage (x EBITDA), (b) Interest Coverage, © Debt/Equity (peers’ equity cushion)
2. Liquidity and maturities — looking for red flags / risk
3. Reproduction value of assets
D: Macro
4. Macro Trends — Is the TAM trending up or down?
a. Secular trends in end markets (e.g. renewables, EVs, OTT)
b. Look at geographic trends; currency effects, unemployment à are these as closely linked to broader population as believed
D: Other
5. Event risk (events coming up); Private Market Value — which buyers could be interested & when?
E: Valuation
- How can I extract value from this business?
o Distressed carveout / cap structure arbitrage?
- Accounting Tricks: Premature / questionable revenue recognition, incorrectly capitalised expenses (should be to match rev. timing) and manipulated cash flows
- Metrics: FCF yield, EPV, ROIC vs. WACC, Gross Margin, Reproduction value of assets
Abbreviated version
Quality Company Checklist:
a. Stable cash generation
b. Growth Opportunities
c. High ROIC
1. Cash Generation
· Product: cost/differentiation/niche
· End Markets
2. Growth
· Type: Volume, Price, Mix
· FCF Margin vs. Growth
3. Cost Structure
· Fixed vs. variable costs
· Gross margin and trend
· R&D / S&M (Scale as source of sustainable competitive advantage)
· (RoA — EBIT/Reproduction Assets)
4. Competitive Dynamics
· Competition: Market Structure (Macro)
· Competition: Competition per deal (micro does distribution give a competitive advantage or are deals competitive)
· ROIC > WACC? (Cash ROIC is better)
· (1) Barriers to Entry & New Entrants
· Checklist:
o Government
o Network effects
o Switching costs / Back-end monopoly
o Demand / supply side advantage (Technology / Intangible)
· Position in value chain (WC / Gross margin / pricing) indicate bargaining power with buyers/suppliers
