Equity Research in an Investment Bank

Equity Research in an Investment Bank – This is part 2 of the Investment Banking Overview – 9 part Series.

In this Part – 2, we will discuss the following –

  • Equity Research in an Investment Bank
  • How Equity Research Makes Money
  • Who are the clients of Equity Research Department


Equity Research in an Investment Bank Video


Transcript of Equity Research in an Investment Bank (Part 2/9)


What is Equity Research?

What is Equity Research

Now let’s move to the various departments with the investment bank the first and most important to start with is research department and when we talk about research their job is primarily to come out with the buy sell recommendation on stocks from the longs time long time perspective and the idea here is that they should be able to advice their client and weather the client should buy or sell the stocks from the stock market so the first questions that we will actually try and answer here is what exactly is research since in we talk about equity research it’s all about from the fundamental analysis doing the ratio analysis doing lot of valuation free cash well to the firm talking about relative valuations so what exactly is research and the how do they really help in making money. The second questions that will try and answer here and then so for whose consumption are we creating research I mean they are basically clients and mono the large set up clients are assets management companies or AMC so will try to see what AMC is all about and the when we talk about research on one side and AMC is an institutional investor are on other side or clients on the other side we say that one is a sell side and other is a buy-side so it is also equally important as a new comer understand the difference between a buy side and a sell side so that’s what we will trying to let’s in first in for most start with an understanding of what is research?

How does Equity Research Work?

How does equity research work

So let us now look at the overall workings of the brokerage or the research department. So what exactly is their job within an investment bank? So essentially what they do is they perform stock research. What do we understand by stock research? We can call this as company research as well and a company research would mean that look at the fundamentals of the company go through the annual reports, identify you know whether the company is doing or bad for the fundamental point of view, look at the future and come up with the buy-sell recommendation on the stock. So essentially we are saying that do the valuation analysis on the company and recommend the buy-sell of the stocks. So these stock recommendations are being done for various kinds of clients including pension fund managers, portfolio managers, retail investors and once they are ok with it the clients actually orders to execute a buy or sell through the sales and trading departments. We’ll see you know how this actually functions in a merit but let me ask you a question here.

Who are the Brokerage Clients?

 Clients of Brokerage Firm

Who are the clients? As we understood the clients could be pension fund manager or you know portfolio managers but clients can take different you know names all together or could be of different kinds. Think about clients who come from the background of being an individual so they don’t represent any organizations. So let’s say you and me I may want to invest in Microsoft stock. So I’m an individual investor so essentially I have money let’s assume that and I can invest small amounts of money in through my account that is one class of investors. These are called as retail or individual investors but please note that when we talk about investment bank providing research services we are talking about guys who are major investors something like high net worth individuals who have millions and millions in the bank account and would like you know someone professional to manage that so for them these are the major investors. There could be institutional investors. So what do we understand by institutional investors? Think about institution so a mutual fund is nothing but a fund or portfolio you know created by a public through an organization. So I mean these pools of funds are then invested in certain Mandate as defined in the investment policy of the mutual fund. Likewise the institutional investors could be companies you know large companies having large balance sheets in cash they want to invest in different stocks. So you know they have a large war chest as such for investments. Likewise pension funds or you know if you want to extend that that could be a part from pension funds it could be insurance company, it could be banks. So institutional investors are large you know investment power houses who invest in large quantum. So when we talk about investment banks, investment banks are the research departments typically cater to the needs of the institutional investors. They may not cater to the needs of you and me i.e. the individual investors.

Role of Financial Modeling in Equity Research

Completing the Income Statement - Part 3So let me now just give you a brief about you know how a financial model actually looks like and what is the actual job of an analyst within the research firm? So as I was talking about that while the investment banks research department prepares different kinds of you know analysis. What their main job is to actually do a financial modeling exercise where they analyze the historical of the company and you know see their margins and you know talk about their fundamentals but they also forecast and they come up with you know forecast numbers of income statements, balance sheets as well as cash flows and if you look at you know forecasting techniques these are very professional techniques and it takes lot of time for someone to kind of build these set of models and at the end of the day there is one single objective that they want to come up with a share price of the stock i.e. the fundamental price. Here let’s say in this case if the analyst had applied discounted cash flow technique, the share price actually came out to be around 87 $ per share that was a fair price. So depending on what the share price comes using these valuation models research analyst recommend the target price and after making this models actually they prepare a research report for the clients. So we had discussed about who the clients are but this is how they actually prepare their research report to doing financial modeling, forecasting, doing valuations, doing peer analysis and then giving out the research reports to these investors. With this understanding of research let us now move forward and look at how do they really make money? Now let me ask you a question that when we talk about the investment bank and integrity investment bank we earlier said that you know there is a research department within the investment bank and we also have the sales and trading department. So there are other departments as well but the one which we are interested in as of now for the point of view of discussion are these two.

How does Equity Research make money?

 How do Equity Research Make Money

Now the question here is that how do equity research firms make money. We know that there are other set of departments which includes M&A, IPO etc. So we’ll come to those discussions later but for the time being let’s concentrate here. So as we have discussed in an earlier videos that we search of the guys who buy and sell recommendations right. Buy and sell recommendations to the clients, so when we talk about clients, you know here we have clients and clients can be divided into two types you know we can say that there are individual investors like you and me then we have the institutional investors. What these guys in the research side are doing is actually you know they are preparing recommendations right. So they are preparing reports in the format of recommendations and they are advising clients whether they should buy or sell. So as my question was how do they make money? Do you for see a possibility that these reports come with price tags or let’s say $ 100 per report, $ 200 per report and they sell it directly to the clients is it or the earning channel from this client slightly different? Now if you want to see what the real answer is assuming and if we assume that these reports are actually paid reports then we would be assuming wrong. These reports are not paid reports in fact in most cases they are given for free. So when we talk about giving these reports which are you know prepared after doing some heavy analysis referring to lot of data bases, spending time it involves money right? Eventually given it for free. So how do this whole process actually works as a money making entity. So what happens is let’s say if you are technology analyst and let’s assume that you used to cover Microsoft ok and for that you have given a buy recommendation. Now that you are in discussion with one of the mutual funds and this mutual fund or Hedge Fund actually got excited with your story about how and why Microsoft is a buy? Now with this mutual fund would be excited to actually buy their stock. May be one reason is that the things or the elements which you have looked at in terms of research were overlooked by other research houses and now mutual fund is kind of convinced that this is a strong buy. So what they will do is essentially they will; they want to own this stock now. So they will ultimately let’s say give a possibility of buying Microsoft shares to an extent of $ 10 million. So how will these trades get executed 10 million or 20 million or 30 million or 100 million? So this mutual fund do you think that they will go into open market and find sellers of Microsoft? No they will not do that this is not what they will do. They will actually approach the same investment bank to execute the trade for them.

Sales and Trading

So the execution responsibility again lies with the brokerage firm but research guys are not capable or not made for executing the trade. So that’s where the entity called sales and trading comes into the picture. So here sales and trading department which we will again discuss this in a bit more detail later but for the time being assume that let’s say $ 10 million that needs to be bought for this mutual fund this will be done through this sales and trading department and on this basically the brokerage house of the investment bank will charge commissions. So let’s assume 1%, 2% etc. Now this is how the research guys are actually making money for the investment bank and why probably the sales and trading guys are needed to execute this we will discuss that in our next video tutorial. Now that we have understood pretty much in a shell that you know research department make money indirectly through the clients the clients can be various types like institutional investors and one of the being asset management companies.

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