Research process

"Inderes starts coverage of company X with an EUR Y target price and Z recommendation." This typically summarizes the first step in the coverage of a new company and the underlaying research work that has taken dozens of hours when we ramp-up coverage of a new company.

However, the recommendation and target price are only the cherry on top in research and thorough company research requires a huge amount of background work.

The recommendation and target price are only one conclusion or outcome of the analysis work, which may be based on wrong conclusions or assumptions that will not materialize in the future. Therefore, we believe that an informed investor should assess the underlying assumptions of the recommendation and target price and consider whether they agree with them and whether they want to bear the risks related to the assumptions and estimates made in the analysis.

We will now discuss our normal research process for a new company entering Inderes’ coverage point by point.

Analyzing the business and actual development of the target company

Company analysis always starts with learning about the target company. At the beginning of the analysis process, focus is on learning about the new company's business model. In practice, we learn what kind of business (B2C or B2B) the company operates in and what the earnings logic of the business is. In the early stages of the analysis process, we take a deep dive into the company's historical development and current financial situation, which in practice means analyzing the company's historical financial statements.

At this stage analysts often build a preliminary base for their estimate model. Next to historical financial development, interest also focuses on major events that have affected the company in past years, such as acquisitions or changes in ownership structure. When learnings about a new company, the analyst also reads about the strategy and possible financial targets of the company. 

In the early stages of the analysis process, the best information sources are often the company's own publications, annual reports, interim reports and CMD materials.

Strategic analysis

Once the analyst has developed an overall view of the new company's business, the process moves to strategic and business environment analysis. In practice, at this stage, a basic understanding of the target company's industry and competitive position is sought.

Interesting variables when analyzing the industry include the size of the industry, the market share of the company, the expected growth rate of the industry, and the overall profitability level. At this stage, the analyst also seeks an understanding of the company's value chain position and possible competitive strengths or weaknesses, the strategic differences between companies and the dynamics that affect the industry, like a new disruptive technology.

Familiar tools from strategic literature like Michael Porter’s model of five competitive forces or SWOT analysis can be utilized in the strategic analysis. 

In strategic and business environment analysis, the availability of background data varies significantly from company to company. Most typical information sources are materials published by the company and competitors, market surveys conducted by industry lobby groups or external consultants, and Statistics Finland's statistics.

Estimates

Assessing the target company's business and actual development, as well as strategic analysis, provide the basis for future estimates. Before preparing the final estimates, the analyst will typically meet with the top management of the target company, with whom they review the company's business in detail and seek answers to questions raised during the analysis process. There are often many questions and they range from detailed questions concerning figures to broader strategic themes.

After the management meeting, the analyst should have the ability to make justified estimates of the company’s future development. A certain reference framework for the company’s short- and medium-term development may be provided by the company's guidance and financial targets. However, in a credible analysis, estimates cannot be built solely on these, the analyst must take a position on the credibility of the targets.

In their estimates the analyst assesses, e.g., the company's future growth and profitability development and how much the estimated growth ties up capital in the form of fixed investments and working capital. In addition, the estimates take a stand on what kind of profit distribution is expected from the company, considering the company's own profit distribution and capital structure targets. If, for example, there is considerable uncertainty about the future of the target company due to its early development stage, several alternative future scenarios can be made.

Valuation 

After the estimates have been prepared, the process proceeds to defining the target company's required return and valuation.

When determining the required return, we do not assess the company's risk level through the market beta or so-called "fundamental beta” (financial statement-based beta), the applied required return reflects the analyst's subjective view of the target company's risk level. The applied required return is also proportional to the other companies we monitor. 

At the valuation stage, the analyst forms a view of which valuation methods should be used to examine the target company. The applicable valuation methods vary from company to company, but in most cases the valuation is approached with at least some of the following angles:

• The company's absolute valuation multiples
• The historical valuation multiples of the company and industry
• The current valuation multiples of the peer group DCF model Sum of the parts calculation
• The valuation multiples applied to acquisitions in the industry

Valuation is not limited to just completing the actual valuation, but the analysis aims at highlighting factors that may have a negative or positive impact on the company's valuation. In addition, a justified valuation explains the sensitivity of the valuation to key variables.

The valuation section typically also aims to assess the expected return on the share over the next few years and to briefly summarize the investment case.

Summary

This article was a summary of our normal research process for a new company entering Inderes’ coverage. It should be noted that company monitoring is a continuous process, which means that the analyst systematically seeks new information on, e.g., these areas and reviews previous conclusions based on new information. The research process is never really complete. 

We also note that we do not believe there is a single correct way of carrying out company analysis. The research process is always a reflection of the analyst but we at Inderes have tried to define the areas we consider a prerequisite to make an informed assessment of the company under analysis.

In the next sections, we will look at the above topics in more detail.