Valuation analysis is part of the investment decision process, which estimates the value of an asset. The research holds that the two main approaches to the valuation process are the top-down, three-step approach and the bottom-up, stock-picking approach. Although both approaches are equally used by fundamental analysts and technicians, they differ in the way each one perceives the importance of the economy and industry in the valuation analysis of a firm.
The top-down, three-step-valuation approach holds that regardless of the qualities or abilities of a firm the macroeconomic environment and the industry have a major impact on the success of the firm and the rate of return on its stocks.
To illustrate this, assume that an investor owns the stocks of a financially strong company with a record of strong financial results. If the investor owns the shares during an economic expansion, the sales and the earnings of the company will increase, thereby increasing the return on investment for the investor who owns the company’s stocks. Conversely, if the investor owns the stocks during an economic recession, the sales and the earnings of the company may shrink, thereby, causing the stock price to decline and lowering the return on investment.
When using the top-down valuation approach, investors seek to estimate the future value of a security and its rate of return by analyzing first the macroeconomic environment, including the interest rates, inflation, GPD and so on. Then, they analyze the industry that a particular company operates in, the competitive forces that the industry culminates, and how these may affect the company’s performance. Then, they analyze the financial and operational performance of the company by tracking its historical performance and estimating the potential for future growth.
The bottom-up, stock-picking approach focuses on the company per se. Investors who use the bottom-up approach study primarily a firm’s fundamentals, such as sales and earnings figures, balance sheet and cash flow statements, and they perform a financial statement analysis to estimate the company’s effectiveness. The balance sheet reflects managerial effectiveness and wise allocation of capital. Strong cash flows indicate that the company has the ability to finance its operations without raising additional debt.
Furthermore, investors evaluate the size of the market to obtain an accurate estimate of the company’s growth potential. Companies with the ability to consistently increase their market share and expand their operations into new markets are considered successful.
The Bottom Line
The academic studies favor the top-down valuation approach, holding that the macroeconomic environment has a significant impact on a company’s performance and profitability. In addition, there is a strong correlation between stock prices and the phase of an economy, particularly the economic expansions and contractions. Furthermore, the bottom-up valuation process requires superior stock picking skills to identify stocks that trade over or under their fair market value, and the cognitive biases of investors can lead markets off-center.
In conclusion, the top-down, three-step-valuation approach is preferred over the bottom-up, stock-picking valuation approach because it doesn’t take into account the subjective preferences and psychological biases of investors. By considering the broader macroeconomic environment and the market, the top-down valuation approach determines the value of a security based on market consensus rather than on the individual traits of investors.
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