Three Step Valuation Process

The value of a financial asset is primarily subject to its quality and profit potential. However, the economic environment and the industry performance are equally influential to the value of a security and its rate of return.

The top-down, three-step valuation approach holds that both the economy/market and the industry effect have a significant impact on the total returns for individual securities. To illustrate this, we assume that an investor owns the stocks of a viable and successful firm. If the shares are owned during an economic expansion, the sales and the earnings of the firm will increase thus increasing the returns the investor receives from owning the firm’s stocks. However, if the stocks are owned during an economic recession, the sales and the earnings of the firm will decline and consequently the stock price will decline as well. Therefore, in order to estimate the future value of a security and its rate of return it is absolutely essential to analyze the outlook for the aggregate economy and the industry that the firm operates in.

In the following pages, the paper analyzes the three steps in the valuation process which involve (1) the influence of the economic environment on the firms, (2) the importance of the industry environment on the firms and (3) the fundamentals of individual firms.

Economic Environment

The economic environment is mainly driven by fiscal and monetary measures which influence the aggregate economy of a country and consequently all the industries and firms within the economy.

Fiscal policy influences the direction of an economy through changes in government taxes or fiscal allowances. For example, imposing additional taxes on income, liquor, cigarettes, and gasoline can discourage consumer spending, while increases in government spending on unemployment insurance can offer financial relief. Fiscal policies influence the business environment particularly for firms that rely on such expenditures. At the same time, we should consider that government spending has a strong multiplier effect. For example, if road building is increased, then the demand for concrete materials will increase. Consequently, the profitability of construction firms will increase.

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Monetary policy influences the direction of an economy through measures that control the supply of money, the cost of money and the interest rates of the economy. For example, a restrictive monetary that targets to reduce the growth rate of the money supply, it can reduce the supply of funds for working capital and expansion of the economy. Similarly, a restrictive monetary policy that targets the interest rates, it will increase firms’ costs and will make money more expensive for consumers.

Other factors that affect the economic environment are inflation, political turmoil, international monetary devaluations and terrorist attacks.

Industry Environment

Industry analysis is important because it determines a firm’s business risk based on sales volatility and operating leverage. In competitive industries, a firm’s position and financial leverage is subject to the competitive moves of other firms in the industry, but also to the status of the firm as entrant, serving, or exiting firm (MacKay & Phillips, 2005).

Economic trends affect industry performance. Industry performance is related to the stage of the business cycle. Different industries react differently to economic changes at different stages of the business cycle. Therefore, industry analysis takes into consideration the stage of the business cycle that a firm is when the analysis takes places.

Industries are classified into cyclical and non-cyclical. Cyclical industries (steel, autos) perform better when the aggregate economy expands and suffer when the aggregate economy contracts. Non-cyclical industries (retail food) are stable during recession, but they do not experience a significant growth during expansion. Investors should examine if the firm belongs to a cyclical or non-cyclical industry in order to make the right investment decision in the right timing.

Another important consideration when analyzing the industry environment is the risk that international companies undertake when engaging in international markets. Firms that sell their products/services in international markets can benefit of suffer from shifts in the foreign economies. For example, the fast-food industry (McDonalds, Burger King) often experiences low demand in the domestic market and growing demand in the international market.

Company Analysis

After having forecasted the industries that can possibly outperform the market, investors choose specific firms based on their performance as reflected in their fundamentals. Financial ratios and cash flow values are significant only when compared to industry averages.

Company analysis aims at identifying the best firm in the promising industry. Investors need to examine historical data and project them in their estimates for future performance. After they have determined the firm’s value, they should compare the estimated intrinsic value to the market price in order to make the best investment decision making. The goal is to identify the undervalued stocks in the promising industry and to include them in the portfolio based on their correlation to the other financial assets in the portfolio (bonds, mutual funds and cash). However, the investor has to be fairly certain the firm will be profitable in the future in order to consider its stocks to be undervalued.

The bottom-up, stock-picking approach

The bottom-up, stock-picking valuation approach holds that most effective way to estimate the value of a financial asset is to examine a firm’s fundamentals and historical data. Advocates of the bottom-up valuation approach typically, use stock-screeners in order to check on specific firms based on certain variable constraints that filter out any companies not meeting the specified criteria.

The bottom-up valuation approach does not consider at all the state of the economy because it asserts that successful firms can be successful in any market environment. In this context, bottom-up approach is a great way of discovering small cap firms operating in less attractive industries. If fundamentals make sense, bottom-up investors invest in such firms.

Bottom-up valuation approach studies primarily sales and earnings figures. Strong earnings and sales in the present are essential, as the firm is evaluated on its current intrinsic value. Future earnings potential is also significant, but typically, bottom-up approach focuses on a purchase that is good today, not in the future.

Studying the potential market size is also required when investors use the bottom-up valuation approach. Although market size cannot be estimated accurately, still weighing its potential provides a good projection of the earnings potential a firm can achieve.

Studying a firm’s balance sheet and cash flow statement is also essential. Balance sheet reflects managerial effectiveness and wise allocation of capital. Strong cash flows depict a firm which is able to finance its operations without raising additional debt.

Finally, information about a firm’s market share is also required, because the bottom-up valuation approach asserts that successful firms consistently increase their market share and expand into new markets with solid growth prospects.

Top-Down or Bottom-Up Valuation Process?

After having analyzed the features of top-down, three-step and bottom-up, stock-picking valuation approach, the paper focuses on a comparison of the two processes in order to conclude which serves the investment decision process more effectively.

The three-step valuation process is broadly analyzed by academic studies. Research findings assert that, typically, changes in a firm’s earnings are subject to changes in the aggregate corporate earnings and changes in the firm’s industry. These findings consistently demonstrate and justify the notion that economic environment has a significant effect on the earnings of a firm. In addition, studies have found that there is a relationship between aggregate stock prices and economic series supporting the view that that there is a relationship between stock prices and economic expansions and contractions (Moore, 1983).

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An analysis on the relationship between rates of return, industry performance and corporate earnings showed that most of the changes in individual stock returns are explained by changes in the rates of return of the firm’s industry. Although, over time the importance of market effect declines and the industry effect varies among industries, the combined market-industry effect on a stock’s rate of return is significant (Cavaglia, Brightman & Aked, 2000).

Also, effective investment decision making requires primarily effective allocation of assets in the portfolio, which can be achieved only if investors are aware of the broader environment a firm operates in. Asset allocation guides investors in regards to (1) the ideal geographical allocation (2) the ideal industry allocation and (3) the ideal portfolio allocation i.e. proportion that each class of asset (stocks, bonds, mutual funds and cash) should contribute to the portfolio (Cohen, 1996).

On the other hand, the bottom-up valuation process is challenged by research studies, which assert that it requires superior stock-picking skills in order to identify undervalued stocks among so many stocks that trade around the globe (Mikhail, Walther, Wang & Willis, 2006). The reason is because a lot of the information provided about stocks is not measurable and therefore it cannot be evaluated. Managerial effectiveness is reflected in a firm’s fundamentals, i.e. the quantifiable aspects of firm. However, investors need to get information on a firm’s qualitative aspects as well, such as competitive advantage, and employee performance, in order to assess if a firm can remain viable in the future.

Also, stock-picking is highly subject to the cognitive aspects of the investors and this complicates the assessment of a stock’s performance. Investors, driven by emotion, can lead markets off-center (Frankfurter and McGoun, 2000).