Setting and arguing recommendation

Before reading this section you should have read the section "What is important in analysis to try to estimate?". It discusses also the basis of recommendation and different valuation cases thereby. We also recommend that you would use valuation scatter in estimating the valuation of your target company.

The key factors when setting investment recommendation is that an analyst

1) Makes justified target price assumption of the company based of future financial perfomance and current valuation (with e.g. valuation scatter)
2) Compares the company (valuation multiples and financial perfomance) to other companies (with e.g. valuation scatter) and
3) Above all gives transparent and realistic arguments for all the factors he/she has pondered hereby, so that an investor (a customer) can see which of those arguments are reliable and which perhaps not.

The recommendation should never be based on your unexplained "feeling" and the recommendation should always be based on, and be in line with, the long-term target price set by an analyst.

Setting target price

What should the target price then be? There is no exhaustive answer on that question. There are several valuation methods, and important is that you shouldn't blindly trust one. Instead use many methods together and then set some kind of consensus target price.

Different valuation methods

Relative valuation (comparison with other companies):

For example if some multiples (e.g. P/E, EV/EBIT) are lower/higher than the ones for companies in the same industry (or companies in general). Be careful using this method, because the variable of your company may well be at the "right" level when the industry is over/undervalued. Furthermore the company itself might have such characters that justify lower relative valuation than its peers: weaker profitability etc. Hereby you can use e.g. valuation scatter.

Absolute valuation:

Some variables are very low/high. For example P/BV (Price / Book value) is low (e.g. below 1) despite of that company's profitability (e.g. ROE %) in the future seems good (e.g. better than 20% in the same time as P/BV is below 1). In this case you should recommend buying this share, because when the markets notice that profitability will improve, the P/BV (the share price) rises. Hereby you can also use e.g. valuation scatter.

DCF (discounted cash flow) value:

One thing that should also be in the line with the recommendation is the DCF value of share price. The DCF value should rather be supportive for the recommendation than be the factor on what the recommendation is based on. In other words, it is preferred that you adjust the DCF value to support your recommendation, and not vice versa, because DCF can be manipulated easily: by manipulating profitability or growth estimates in distant future you can always make DCF fair value look like as the company is "cheap".

DCF parameters (mid-term growth and profitability) should be set at the level, which makes your the DCF fair value to be about the same level as your target price (which in turn is defined by other means than DCF). If that is not easily possible (requires too high or too low estimate parameters), then it is of course a sign that something is wrong and you should rethink your target and the whole valuation. Thus the DCF acts best as a kind of "reality check": it checks whether your target price is approximately at the right range.

Remember that good profitability and good earnings development always reflect the share price. In the very long-term share prices follow the return on equity (ROE%) of the company. In the short term does not as the current market value can be far from equity book value and as current valuation (P/BV) reflects the whole future and not just one or two years.

Do not forget to compare to other companies

Analysts sometimes tend to "fall in love with some companies they analyse". This happens especially if the companies are very good at what they do. This sometimes ends to buy recommendations even in cases when the company or the whole industry is overvalued. That's why it is vital that you remember to compare your company to other companies and use that information when setting the target price and recommendation.

Great help for doing comparison gives Multi-criteria rankings (MCR) page in ValuViews where companies are ranked based on different variables. If your opinion differs a lot from MCR lists, you should give very clear justification why you have ended up on your decision. Another, perhaps even more illustrative comparison tool is valuation scatter which you should also use hereby.

For example, if the company you are analysing is located on the top of the MCR or scatter list and your recommendation is reduce, you should argue why you have decided this way. However, the MCR-list is not pure truth, so don't be afraid to disagree with it. For example a company may well be at the bottom of the list because of current bad financial performance, but the financial performance might be improving in the next years (there are already signs of that but profitability lags the other signs like improved customer orientation or improved operative efficiency which can not perhaps be seen in EBIT because of overcapacity or something like that) and the market may have not noticed it yet.

Briefly, if the company is "bad" at the moment, it doesn't mean that will always be "bad" and cannot improve - but there must be reasons and proofs of that improvement - otherwise it might be bad for next ten years. So do not just expect that something must happen.... However, one common feature of really good investment target is that market is not yet aware of something that will happen.

Check list to see if the company really is cheap

The following list should be checked if you bump into company that looks very cheap with relative valuation: cheap P/E, EV/EBIT, P/BV etc. ratios:

Does the drop in earnings seem obvious (bad competitive position, cyclical fluctuations downwards inevitable in the future for the whole industry, no superior competitive strengths that would protect from future competition etc.)?
Are there some signs in the owner structure that might weaken the position of company in the long-term (main owners might want to take all the cash out of the company etc. with transfer pricing - in situation where unlisted parent company owns listed daughter company is always a very big risk - especially if they have common business and therefore room for overpriced transfer pricing in transactions)?
Are there any other features that may weaken the position of a company in the future?

Summary

Use long-term investment horizon when setting the target price and recommendation.
Use complete yet understandable arguments to explain why you have ended up to your recommendation.
Don't set recommendation separately from the other companies (MCR and scatter lists).
Don't use only one method to value the target price.
Check that the DCF-value is in the line with your recommendation (adjust fair value if possible, if not possible (requires unrealistic future estimates) then rethink and adjust target price and recomm.).
There is not one right way to value the price of a company, thus use many methods. Use relative and absolute valuation and try to find hidden strengths and weaknesses that market may not know yet. Based on these decide (long-term) target price.